Libor Plunge Risks Wreaking Havoc in $670 Billion CLO Market

If three-month LIBOR sinks below 1 percent, it would be a major headache for the market.

(Bloomberg)—Tumbling interest rates are throwing a wrench into the collateralized loan obligation market that could eventually lead to dust-ups between different stakeholders, market watchers say.

At the heart of the issue is the plunging London interbank offered rate. Buyers of CLOs, which are tied to the gauge, are increasingly factoring the prospect of negative fixings into their due diligence as the Federal Reserve slashes its benchmark to near zero and three-month Libor sinks below 1%. While the likelihood of it going negative remains small, it would be a major headache for the $670 billion market that buys more than half of all leveraged loans.

That’s because roughly one in five CLO tranches lacks any sort of Libor floor — thresholds that guarantee minimum payouts to debt investors should the reference rate plummet. If Libor were to eventually fall below the spread on these structures, the negative all-in coupon could mean CLO debt holders would in fact owe money back to the issuer. That may benefit buyers of the equity portions of the capital stack, but industry veterans say CLOs are simply not legally or operationally equipped to handle a reversal in cashflow.

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