US CLO Managers See Smooth SOFR Transition

Almost five years after regulators first began phasing out LIBOR, the US CLO market's first few months of activity in 2022 saw a series of successful new issues fully referencing the Secured Overnight Financing Rate ("SOFR").   After an unprecedented year of CLO issuance in 2021, this helped to inject considerable positivity into the transition to the new reference rate and it is clear that managers are beginning to successfully adjust to life after LIBOR.

Of course, there had been considerable apprehension in terms of how the CLO market would handle the switch to the new benchmark and a number of deals were pushed to completion ahead of LIBOR discontinuation at the end of 2021, in anticipation of potential issues.  Any concerns that the market would not comfortably digest the new CLOs with SOFR-linked liabilities, however, have now been assuaged with this good start to the new era.

Pricing of the initial SOFR CLOs was relatively in line with expectations, with Triple A notes generally in the low to mid 130 basis points above three-month SOFR range.   

The presence of static deals among the early SOFR supply is perhaps not especially surprising, given that the underlying collateral is still adjusting to the new landscape and the availability of SOFR loans is still relatively limited. 

There has been a notable trend of shortened non-call periods in the SOFR deals, which would facilitate early refinancing, such as the one-year non-call period on the Fortress deal.  This appears to be another indication that the market is still adjusting to SOFR and arrangers are conscious of the potential need to reset transactions in order to improve their financial mechanics.  It is likely the market will see some significant refinancing activity in the first quarter of next year as a result.

Interestingly, a small number of CLO managers have already incorporated applicable margin reset ("AMR") provisions into their documentation, which allows them to refinance debt within a CLO while keeping the underlying loans in LIBOR.  The AMR provisions allow managers to use an online auction process, which also cuts costs for managers sourcing loans, as it is treated as a secondary market transaction rather than a primary deal.  Reports indicate there are a handful of CLOs which will exit non-call periods this year that are eligible for AMR refinancing.

Having previously examined some of the fallback language included in our clients' new CLOs, in anticipation of the LIBOR discontinuation, it emerged that having initially favoured supplemental language, with the inclusion of specific trigger events as well as mechanisms for negotiating a new reference rate, the trend moved towards hardwired language with clear triggers and defined successor rates and spread adjustments.  As the discontinuation date moved closer, deals tended towards a hybrid method, which included hardwired fallback language with a waterfall that could be implemented without investor consent, with managers having the flexibility to choose and implement an alternative reference rate.

Widening spreads in the market, however, amid heightened macro concerns and circumstances globally, also has the potential to impact CLO refinancing activity.  Research¹  suggests some CLOs could be out of the money before the end of year, compounding the increased cost of liabilities with the market transitioning away from LIBOR and possibly incurring the Fed-recommended 26.2 basis points above-market credit spread adjustment.

In the context of the positive start to the replacement of LIBOR with SOFR in new CLO deals issued at the start of this year, the Maples Group is pleased to have acted in a legal and fiduciary capacity on all of the new SOFR US CLOs to price during January 2022. While we anticipate that further adjustments to the new regime will play out over the course of this year, we will continue to update our clients on any trends or technical changes that become apparent in the market as the transition evolves.
For more information on the replacement of LIBOR with SOFR, please click here to get in touch with our Structured Finance team.