Fair Oaks Reflections – Issue 8
4 July 2019
THE VALUE OF INTEREST RATE FLOORS IN EUROPEAN CLOs
While we typically think of CLO debt as a floating-rate investment paying a margin over Euribor, since 2015 most European CLOs have included a Euribor floor set at zero. They have thus effectively paid fixed rates of interest since 2015 when 3m Euribor dropped into negative territory.
The floor does not create a mismatch or interest rate risk for CLO equity investors because almost all loans held by European CLOs also contain a Euribor floor set at zero. It does, however, give CLO debt an interesting profile as it benefits from interest rate increases (above zero) while being protected from interest rate decreases. Some other structured product investments, such as European ABS and RMBS, have floors but these are on the coupon rather than Euribor and therefore do not provide the same protection.
The value of the embedded floor in European CLO debt has increased over time as the ECB has repeatedly extended support to European markets and expectations of future Euribor rates have fallen. For example, the expectation for 3m Euribor in June 2021 fell from +0.60% at the end of 2017 to +0.10% at the end of 2018 and to -0.40% at the end of June 20191.
Expected future 3m Euribor rates1
Valuing the Euribor floor is not straightforward since the tenor of a CLO is uncertain, i.e. it depends on when the equity investor chooses to refinance or call the CLO. Some investors ignore the floor and focus on spread, undervaluing Euro CLOs compared to fully floating alternatives, or add the current floor benefit (0.35%) to the spread, effectively assuming that Euribor remains static. Standard CLO market pricing tools use expected forward Euribor rates, currently valuing the floor at 0.43% p.a. for a 2-year (expected life) bond, 0.30% p.a. for a 5-year bond and 0.25% p.a. for a 6-year bond1 (decreasing with tenor as Euribor is expected to increase, making the floor less valuable).
Applying standard option pricing, taking into account the volatility and uncertainty of future Euribor rates, we estimate that the value of a Euribor floor struck at 0% is 0.51% p.a. for a 2-year tenor, 0.48% p.a. for a 5-year tenor and 0.47% p.a. for a 6-year tenor2. However, as the Euribor floor is linked to the tenor of the CLO, the inherent uncertainty makes it difficult to fully monetise the benefit of the floor.
US CLOs also include zero floors. Although USD 3m Libor has never been negative, these floors still have value. As forward curves do not predict Libor below zero, most investors assign no value to the floor. Option pricing puts the floor value at a low but still positive 0.01%, 0.04% and 0.05% p.a. for tenors of 2, 5 and 6 years respectively2.
(1) Source: Bloomberg.
(2) Source: Bloomberg, 2-Jul-19. Upfront premium divided by tenor.