Libor floors boost CLO equity returns

Libor floors have given a big boost to CLO equity tranches recently, notes Morgan Stanley in its CDO Market Insights report published last week. This feature, which puts a floor of usually between 1.5% and 3% on the rate over which loans pay interest, have been included in many new loans issued in the past couple of years and also added to many existing loans through amendments. Since CLO liabilities have no such floors, deals that hold a large proportion of assets with Libor floors benefit from a mismatch which increases the amount of excess spread payable to equity.

Morgan Stanley finds that 23% of CLO portfolios include loans with Libor floors, with the highest holding of these assets being 84%. The bank models the impact of Libor floors on equity distributions, and finds that the net present value of a £38.7 million equity tranche would be $37.9 million if the portfolio had no Libor-floor assets. However, if the same CLO portfolio consisted entirely of loans with Libor floors, then the net present value would be $51.8 million.

Naturally, the higher the proportion of these assets, the greater exposure the deal has to a future rise in Libor which would wipe out the benefit. The report suggests that investors can hedge this by buying Libor caplets.