Tuesday, August 11, 2009

How to Increase Loan Returns: LIBOR Floors and OID

High Credit Spreads Match High Credit Risk
Since the credit crisis began in the summer of 2007, and especially since the credit markets fell of the cliff in the fall of 2008, we have seen credit spreads in the loan and bond markets increase dramatically. Some investment grade companies today are paying spreads that were reserved for high yield companies just 3 years ago. Of course, the higher spreads correspond with increasing credit risk brought on by the recession and by investors' declining appetite for risk.

Lower LIBOR is Good News for Borrowers ...
One piece of good news for borrowers is the dramatic decrease in LIBOR, the basis over which most corporate loans are priced. Although there have been some disruptions in the LIBOR market (like the fall of 2008), this rate generally tracks the Fed Funds rate. As a result, LIBOR has come down from over 5% before the crisis to well under 1% today.

Source: Bloomberg

... But Loan Investors Still Get Paid
Loan investors, especially institutional investors, feel the pain when LIBOR goes down. So in addition to higher spreads, loan arrangers are using these two structures to increase the returns on term loans (especially Term Loan B's) and jump-start the market:
  • LIBOR Floor: Borrower and lender agree that the basis for the loan will be THE GREATER OF actual LIBOR (currently under 0.50%) or the agreed upon floor. Floors in the market today range between 2% and 3%.
  • Original Issue Discount (OID): The loan is sold to investors below par and repaid at par. The difference is the OID, which in todays market is anywhere between 1% and 10%. You can think of the OID as another form of an upfront fee for investors.

1 comment:

Arthur James said...

With reference to OID, my bank had alot of leveraged loans that were originated at libor + a couple of basis points. Credit crunch hit before syndication started/completed and therefore pushed the margins up signficantly. Although the docs allowed for pricing flex (increase in the margins by a certain level), there was still no syndication market. So we effectively arranged for the client to pay us an OID. I think of the OID as the present value of the future incremental inflows that would have resulted from the higher margin.