Transitioning Legacy GBP Libor Loans
This article looks at the transition of legacy sterling loans from LIBOR to SONIA risk-free rate, as governed by English law under the UK regulatory regime. It will cover what is a suitable replacement for Sterling LIBOR, the composition of the new rate and review the recent note published on credit adjustment spreads. This article is for educational purposes only.
Loan Markets and LIBOR
Financial institutions often act as single lenders of bilateral loans to borrowers or as Agents administering and servicing a syndicated facility (for multiple lenders) providing loan financing to borrowers (the ‘loan market’). Borrowers can be varied, in this article we will look at investment grade corporates only. Legacy loans that are part of leveraged finance (e.g. M&A and equity financing) or export financing may have additional features that are not covered here. [1]
In January 2020, the FCA and the Bank of England issuing a joint statement requested firms to:
- Promote and use new risk-free rates (‘RFR’), e.g. the Sterling Overnight Index Average (‘SONIA’) before the end of 2021
- Transition legacy transactions, including “tough legacy” contracts (including loans, derivatives, bonds and mortgage products) [2]
In April 2020, given the impact of the COVID-19 pandemic, the FCA and the Bank of England updated their target date for ceasing new issuances of Sterling LIBOR loans from Q3 2020 to the end of Q1 2021. What didn’t change was the progress required to ensure by Q3 2020 that new and refinanced Sterling LIBOR loans would have formal documentary mechanics to transition to new rates, rather than just rely on “fall-back” rates (‘fallbacks’).
Existing loans referencing LIBOR may have documentary fallbacks and alternative rate mechanisms. However these may have been originally drafted where such provisions were to be triggered when there is an interruption of LIBOR settings of a temporary nature.
Some provisions, typically in syndicated lending, may trigger the rate to an individual lender’s ‘cost of funds’ - which practically may be difficult for both lenders and borrowers to either calculate or agree. The borrower will be exposed to the credit standing of the lender, which may have higher funding costs relative to its competitors. Recently, however, syndicated loans are referencing the Loan Market Association (LMA) ‘screen rate replacement’ language that requires borrowers and lenders to amend the facility agreement to transition to an alternative rate in the event of reference rate discontinuation.
In the bilateral loan market, the terms of provisions are even less standardised given the bespoke nature of the transactions. A high volume of individual bilateral loans are on the ‘standard (short) form documentation’, where there is no fallback and consent from both borrower and lender is required to amend contracts. These borrowers also tend to be further away from the LIBOR transition activity compared to the borrowers on syndicated loans.
Given the uniqueness of the loan market, a market-wide protocol solution (such as the ISDA-protocol solution in the derivatives market) is not appropriate. Rather each loan will have be examined individually, at the documentation level.
The above leads to two questions to address in this article:
- What is a suitable replacement for Sterling LIBOR in legacy loans?
- How can lenders be transparent to borrowers in the composition of a new rate?
What is a suitable replacement for Sterling LIBOR in legacy loans?
The Risk-Free Rate Working Group ('RFRWG') have expressed the view that SONIA index should be the replacement benchmark for Sterling LIBOR for most GBP-denominated derivatives, bonds and loans. [2]
Unlike most derivatives and bonds, loan-instruments have some operational issues when using SONIA:
- New RFR loans are modelled like RFR floating-rate notes (FRNs). These utilise a compounded SONIA rate, which is backward-looking (‘compounded in arrears’). However LIBOR is forward-looking. A LIBOR loan has a rate fixing that when set, the interest payable at the end of the respective period is known at the start.
- With RFR-loans, loan systems and Treasury Management Systems (TMS) need to be rebuilt to calculate interest due on the relevant interest payment date backward-looking compounded with overnight rates
- RFR are near-risk free and require an additional credit margin compared to LIBOR which already incorporates this
- RFR does not have a term premium to compensate lenders for duration. This leaves a credit and liquidity spread ‘pricing gap’ between RFRs and LIBOR rates on an overnight indexed swap basis [3]
- Multi-currency RFR syndicated facilities will have greater complexity on drawdown, as multi-currency LIBOR rates are all set at the same time under the same rules unlike the respective currency RFRs [4]
It’s been estimated that SONIA compounded in arrears can be appropriate for 90% of Sterling Libor loan market by value. The remaining 10% may be appropriate to be on an alternative to SONIA compounded in arrears. The below decision tree may be used the for finding the suitable rate type. Although there has been interest in the loan market for forward-looking RFRs (‘term RFR’), the communication from the FCA is to proceed with active transition rather than await its development. Therefore a suitable replacement for Sterling LIBOR is most likely SONIA compounded in arrears.
Decision Tree Model to determine SONIA Compound in Arrears
How can lenders be transparent to borrowers in the composition of a new rate?
Building on SONIA compounding in arrears, the following features are then needed to transparently communicate the composition of the new rate:
- Official Bank of England SONIA index
- Non-cumulative compounding vs cumulative compounding confirmation (Q3 2020 the Sterling Working Group said non-cumulative compounding is preferred for loans as better able to “distribute interest to the lenders on a pro rata basis”)
- Lag (‘look-back’) period or Observation Shift method confirmation, to enable borrowers to calculate interest payments and lenders to confirm cashflows and service payments. Both are typically 5 days given the RFR loans published. The difference between the methods is in the weighting of the daily RFRs to address non-business days. (Q3 2020 the Sterling Working Group said the lag method is preferred for the same reason as above for compounding.)
- Credit adjustment spread (CAS) to adjust for the term spread between Sterling LIBOR and SONIA. CAS will be looked in depth below.
- Cost of modified fallback positions for the new RFR rate in post-LIBOR world in the event there is a disruption to the index
- Cost of transaction break costs and market disruption. This is hard to say impact given the RFR loan is technically based on RFR daily rates that anticipate the repayment of principal and interest the following day (i.e. no capitalisation or compounding of accrued interest)
Credit Adjustment Spread (CAS)
The credit adjustment spread (CAS) is particularly important for transition of legacy loans. Getting it right will avoid the unintentional transfer of economic value between the lender and borrower from the transition activity.
In September 2020, the Working Group recommended the use of a five-year historical median ('5YHM') as CAS added to the SONIA rate in fallback or LMA replacement of screen rate provisions. However this is only when there is an event, such as a cessation trigger or a pre-cessation trigger specific to GBP LIBOR.
What is the action if the cash markets wish to transition now? (i.e. ‘active transition’)
In December 2020, the Sterling Working Group published further details on two CAS approaches that are starting to come to the foreground for borrowers and lenders to decide when transitioning legacy loans[5]:
- The five-year historical median approach (5YHM)
- The forward approach (the derivative approach of pricing forward-starting swaps)
Let’s have a look at an example on each of these methodologies
The five-year historical median approach (5YHM)
Consider the transition of the below loan from LIBOR to SONIA:
Plotting the amendment date and 5YHM CAS determination date:
Key features of 5YHM:
- Important to be clear when the CAS is applied (as per chart above CAS determination date is after loan amendment date). The Working Group have not suggested an “early opt-in" CAS, unlike the US Alternative Reference Rates Committee (US ARRC) who have for SOFR.
- There is a respective CAS per tenor for the respective GBP LIBOR (e.g. 1, 3, 6, 12 months)
- Fair treatment of borrowers, lenders should assess borrowers ability to confirm 5YHM (it is available on Bloomberg page BISL CAS, license required)
- The spread between GBP LIBOR and SONIA vs. 5YHM can differ substantially, such as in end of Q1 2020 as financial markets reacted to COVID-19
- 5YHM has been used (at date of this publication) in syndicate loans but not in derivatives or loans
- In derivatives markets, 5YHM is referenced in cessation and pre-cessation triggers only rather in active transition (which has instead been using Sterling basis swap market)
- The terms for the Bloomberg page BISL CAS are still being confirmed
- There is good stability in using 5 year median compared to a single observation
Forward Approach
This approach is based on the forward-looking Sterling basis swap market. The original loan pricing margin is adjusted by the linear interpolation of the respective tenors of Sterling LIBOR and SONIA swaps. The interpolated tenor is the maturity of the weighted average life of the existing loan, i.e. amortising principal repayment loan will have short maturity than a bullet loan.
Plotting the amendment date and forward approach CAS determination date:
Features of the Forward Approach
- Timing of forward approach CAS is more sensitive that 5YHM given that basis swap market is dynamic and assumes the CAS is effective at pricing date
- It reflects the difference between Sterling Libor and SONIA for the remaining life of the loan (subject to sufficient liquidity in the basis swap markets), unlike 5YHM CAS which may be higher or lower than the spread on any given day
- Will be more appropriate for transactions linked/structuring with SONIA-FRNs
- Hedging the loan in active transition will be easier given derivative markets will be the basis swap markets, although differences will be present on CAS interpolation maturity vs executed maturities
- Swap bid-offer rates will give different values, swap-mids may be preferred at pricing
- Operational complexity vs 5YHM as bespoke per contract rather than CAS determination date (later would be easier for syndicated facility)
Summary
In the backdrop to transition, there may be additional factors such as the refinancing risk of COVID-19 emergency funding lines and payment holidays that may have a wider impact on the loan market. Transition of legacy loans may therefore require more restructuring than initial scoped repapering or amendments, which can further complicate the process if sufficient time is not given towards it.
Active transition of legacy sterling loans has a path to be aligned with new RFR loans as outlined. As lenders and borrowers consider their own obligations given the regulatory and legal requirements to be in compliance, the loan market is indeed well engaged to deal with the challenges ahead of it.
Travolta Mohan
Disclaimer: all views expressed in this article are my own and do not represent the opinions of any entity whatsoever with which I have been, am now or will be affiliated with. The information is for educational purposes only. No legal, regulatory or commercial advice is given.
[3]https://ibors.fieldfisher.com/loan-markets/
[4] https://www.lma.eu.com/news-publications/press-releases?id=181&search_str=rfr
Senior Banking Transformation Manager | Organisational Leader| Program / Sr. Project Manager | Strategy Executor | Corporate and Investment Banker | High Performer | Available | 07879280854
3 年Well written Travolta.
Global Risk Assesments and Scenarios at NatWest Markets
3 年Excellent article!
Trading Credit Risk Management
3 年Interesting article Travolta. Thanks for sharing