The three-month London Interbank Offered Rate (Libor) has risen more than 60 basis points (bps) from a year ago, to roughly 85 bps currently – and bank loans, as floating rate, Libor-based instruments, are among the few asset classes to directly benefit. With the current move in Libor being driven by idiosyncratic factors, rather than moving in step with a Federal Reserve rate hike cycle, we could see loans benefit more versus other fixed income instruments than they have in past cycles (see table). Moreover, we think recent concerns about corporate borrowers’ ability to manage higher interest costs may be overstated. Finally, the prevalence of Libor floors, along with large holdings in collateralized loan obligations (CLOs), make the impact of rising Libor more nuanced for investors in all areas of today’s bank loan market.
The impact of Libor floors
At current three-month Libor levels, the weighted-average 100 bp floor for the 92% of loans in the S&P/LSTA Loan Index that carry floors is offering diminishing returns in terms of excess spread provided to investors. Meanwhile, loans with no or lower floors will start to see all-in coupon levels rise. Typically, demand in loan retail funds rises in step with Libor, and indeed the outflows we saw earlier in the year have reversed: In the past six weeks, inflows have totaled just over $1 billion, including $365 million in the week ended 25 August. However, because borrowers in the loan market can choose to borrow at one-, two- or three- month Libor, we would not expect to see much of a direct impact on coupons paid to loan investors until one-month Libor tops 100 bps. Still, with the current increase coming at a time of generally robust markets and favorable credit fundamentals, we expect an increase in demand for loans from both retail and institutional buyers.
Mixed picture for CLO investors
The impact of rising Libor is bifurcated among CLO investors. For debt tranche holders, the coupon received will generally rise, given that most tranches (from AAA down to BB) are floating rate instruments based on three-month Libor. And because the current rise is occurring against a steady economic backdrop with generally solid underlying credit performance and low defaults, the increased coupon does not come with increased credit risk in the underlying CLO portfolio.
The first-loss or equity tranches of CLOs, however, have enjoyed higher excess spread arising from the gap between the 100 bp average Libor floor and actual Libor, which was in the mid-20 bps last summer. As this gap narrows, less excess spread is available to equity investors: Morgan Stanley estimates that for each 10 bp increase in Libor, CLO equity distributions will decrease by 0.9%, indicating that distributions are likely down by more than 5% from a year ago. Reduced distributions could cut into new issue CLO demand, particularly given current rapid loan repricing, high dollar prices for accumulating assets, and tight spreads that are already challenging arbitrage opportunities.
Concerns about interest costs may be overblown
Issuers in the leveraged finance market have spent the past several years extending maturities and refinancing much of the debt on their balance sheets with low-coupon, fixed rate debt. Floating rate loans now make up roughly 42% of the total leveraged finance market, and 90% of them have a floor averaging 1%. So with Libor still under that floor, borrowers’ interest costs remain largely unchanged, and the overall impact would likely still be modest even if rates moved above 1%. Interest coverage averages 4x for leveraged issuers today, and even if we see a move to 3% Libor (which isn’t likely for years under the Fed’s expected gradual rate path), we estimate that interest coverage would only drop to about 3.3x‒3.5x (and a coincident 10% drop in EBITDA would likely still leave coverage at 3.1x‒3.2x). Issuers with higher-than-average debt and higher borrowing costs would likely feel a greater impact, but overall we don’t see the rise in Libor driving a major shift in credit fundamentals.
Bottom line: The increase in Libor has drawn attention to the bank loan sector, where unlevered investors should broadly benefit as rates rise, particularly given the backdrop of strong credit fundamentals, supportive market technicals, and valuations that remain attractive in a market searching for yield.