Yesterday Goldman Sachs analyst Bridget Bartlett issued a warning to CLO investors to beware of the “LIBOR squeeze.” As the note points out, over 90% of the $900BN levered loan market has a LIBOR floor set at an average rate of 100bps. LIBOR floors in levered loans became popular in the aftermath of the “great recession” as a way to entice loan investors in a “lower-for-longer” interest rate environment that drove LIBOR rates down to 25bps.
For CLO investors, the LIBOR floor was a beautiful thing with CLOs owning roughly 60% of the $900BN levered loan market. Investments in levered loans carried a LIBOR floor of 100bps while the liability side of the CLO structure floated at 25bps providing 75bps of excess spread. With CLO structures levered at 10x the extra 75 bps of spread boosted equity returns by 7.5% annually. But with the recent spike in LIBOR, that excess margin is fading away.
Rising Libor rates has most directly affected holders of CLO equity tranches, who have benefited from the “subsidy” gained from the spread between Libor rates and the Libor floor on the asset side, while liabilities “float,” and are paid without Libor floors. In the low Libor environment over the past few years, CLO equity investors have benefited from this disconnect between assets and liabilities. A year ago, for example, the 75bp subsidy from the asset side of equity CLOs—calculated as the differential between the spot Libor rate (25bp in July last year) and the average Libor floor (100bp)—would increase total cash payments to equity holders by 7.5% on an annualized basis for CLO equity investors that are 10x levered.
However, as Libor has increased recently, the income that CLO equity investors have earned on the floor vs. Libor arb has stagnated. With only a 20bp differential between Libor spot (80bp) and Libor floors (still at 100bp), the equity distribution from the Libor floor decreases to only 2% per annum compared with7.5% a year ago. CLO equity investors are only negatively affected on the way up to the Libor floor level as the yield pick-up squeezes, but the effect will be neutralized once Libor passes the average 1% floor and the asset side would then float.
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