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TRLPC: Loan investors wary of rising Libor

Managers of Collateralized Loan Obligation (CLO) funds and bank loan mutual fund investors are worried that higher U.S. Libor rates will see smaller CLO equity payouts that will reduce managers income and will also pull secondary loan pricing lower.

Libor rates, which are expected to rise along with U.S. interest rates, are primarily a problem for CLO managers. CLOs raise funding on a floating-rate basis, but their loan interest income is temporarily fixed, which will squeeze returns.

Higher Libor rates will reduce the excess spread that investors receive and reduce returns for CLO equity holders after senior tranches are paid out - until Libor rates are higher than Libor floors.

Coupon payments on loans, which make up the asset side of CLO balance sheets, will not rise until Libor rates exceed Libor floors, which market players estimate will take 18 months.

However the liability side of CLOs balance sheets, which finances payouts to CLO equity holders, is floating rate and will rise along with Libor, which will cap returns in that time.

"As a CLO manager I'm happy to have Libor stay below 1 percent. That time when Libor starts increasing until it is above the floor will be painful for CLO equity investors," a CLO manager said.

U.S. leveraged loans typically offer margins of around LIB+250 along with Libor floors that guarantee returns for investors. Libor floors averaged 100bp in the second quarter, according to Thomson Reuters LPC data.

Investors currently make most of their money on excess spread, which is the 75bp difference between the current U.S. Libor rate of 23bp on June 5 and Libor floors of 100bp.

"Most of the excess return generated today...