“The true [difference] will likely be closer to 10 basis points, if not tighter, versus the 26,” said John Hwang, portfolio manager at Western Asset Management, adding there’s precedence from other markets that have already issued SOFR-priced transactions, and a deal now in the market launched its initial price talk with a 10 basis point adjustment to SOFR, in addition to the credit spread.
The wider the spread adjustment, the more it will erode the asset-liability arbitrage that fuels CLOs, potentially slowing the launch of new CLOs. And the uncertainty of how to price loans over SOFR could encourage further use of Libor this year.
“How robust issuance this quarter will really depend on how quickly we get through this price discovery stage,” Hwang said.
J. Paul Forrester, a partner at Mayer Brown, said the BSL market appears resigned to pricing loans over SOFR, rather than a credit-sensitive Libor alternative such as BSBY, at least for now, and his firm is internally training its lawyers to prepare for the pricing shift
“That’s been a major holdup in our market so far,” Wohlberg said. “Everyone knows that it’s closer to the spot difference today, and 26 basis points is not the right number, but no one is incentivized to be the first mover yet.”
Once the issue is resolved, he added, there might be a cascading effect in light of the record volume of loan issuance available to CLO bonds’ low default rates and attractive yields compared to other investment products.
“Even if there’s some sort of short-term lag in figuring this out, as we hit that bright line at the end of the year or maybe even several weeks before that people will solve the issue, because the volume and demand are there,” Wohlberg said.
Daniel Wohlberg, a director at Eagle Point Credit Management, agreed that the appropriate basis between Libor and SOFR has been an issue in terms of pricing new loans and CLOs pricing over SOFR
“That optionality, which is still evident in the market, has to be squeezed out. And that’s going to take time because it’s really operational stuff that people have to work their way through,” he said.
Hedging term SOFR might be another difficulty. The ARRC recommended this tactic in early July, intending to provide a deal structure more closely resembling Libor and thus facilitating the transition. The dearth of new deals priced over SOFR, however, means there is insufficient liquidity from underlying transactions on which to price swap hedge.
Wayne Farms starts with daily simple SOFR, one of four ways to calculate the daily rate, and becomes a term rate when agent Bank of America determines the term SOFR is administratively feasible, according to Ian Walker, head of U.S. middle market research at Covenant Review. Walker Dunlop starts out with term SOFR and will fall back to daily simple SOFR if term SOFR, which may face similar liquidity challenges to term Libor, stops permanently.
More loans pricing over term SOFR will eventually provide the liquidity necessary to support hedges, but until then CLOs will lack an important tool to mitigate basis risk stemming from the changing mix of SOFR- and Libor-priced loans CLOs will initially hold a as the transition progresses. That suggests CLOs , when the swaps to hedge that risk become more readily available.
Before then, “You’d be putting a deal out there that has a lot of basis risk that you can’t hedge today,” Forrester said.
However, CLOs may hesitate purchasing loans until they have a better understanding of the dynamics on the liability side, where bond payments are made quarterly and there is no floor. CLO investors likely favor the higher 26 basis point spread differential, but CLO managers increasingly see such a wide difference as punitive.