CLO market participants are once again finding themselves scrambling, this time to consider alternatives to the high probability of a financial industry without LIBOR. This follows comments made by the head of the UK Financial Conduct Authority on July 27, 2017, indicating that LIBOR in its current form will be phased out as a benchmark rate and a substitute must be in place by the end of 2021.
In an industry that is still coming to terms with the Loan Syndication & Trading Association's (LSTA) win over federal regulators exempting U.S. CLO managers from adhering to risk retention requirements, it is believed that the potential elimination of Libor could increase the volatility of the well-established benchmark rate and pricing of the underlying collateral obligations. This could reduce the ability of collateral managers to hedge interest rate risks, as well as negatively impact the liquidity of the secured notes.
Whilst the ultimate impact is yet to be determined, it is important to understand why this is of concern to the market. CLOs are twice exposed to interest rate risk as LIBOR is the benchmark used not only for the underlying loan assets, but also for the liabilities issued by CLOs.
The market has already started to respond by adding provisions to deal documents, to ensure there is flexibility to allow for an alternative rate to be selected if LIBOR ceases to exist thus eliminating the need to amend the CLOs indenture. We are seeing increased discussions about the LIBOR replacement on our transactions with innovative fixes being introduced into deal documents. Whilst provisions will vary from deal to deal as to how to determine the effectiveness of the alternate rate, the collateral manager is often appointed as the relevant party to make this selection.
A change in the base rate also has potential adverse tax consequences for U.S. investors, who may be deemed to be exchanging a debt instrument following a rate change from Libor to the alternate rate and, consequently, may be required to recognize a taxable capital gain or loss.
Most recently, the New York Fed debuted the Secured Overnight Financing Rate (SOFR), a benchmark U.S. rate and widely seen as the possible replacement to LIBOR. The New York Fed also started publishing the Broad General Collateral Rate (BGCR) and the Tri-Party General Collateral Rate (TGCR).
Undoubtedly market participants will continue to monitor this issue and adapt accordingly. Only time will tell if SOFR is proven to be a reliable benchmark in the CLO market. Notwithstanding the potential far-reaching implications the demise of Libor has on CLO structures in general, this market has proven time and time again its robustness and resilience to withstand equivalent forces.
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