NEW YORK, April 13 (LPC) – A health emergency of unprecedented proportions has added another layer of complexity to the US loan market’s transition away from a key lending benchmark used to set interest payments on trillions of dollars of investments as the deadline to move to a new rate rapidly approaches.
Companies including General Electric, General Motors, and American Airlines all tie a portion of their loan interest payments to the London interbank offered rate (Libor). Following scandals linked to the rate stemming from the great financial crisis, a UK regulator said that by the end of 2021, markets should move to a new lending benchmark.
A group backed by the Federal Reserve (Fed) has recommended a shift to the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by US Treasury securities. Libor is an average rate banks say they would charge to lend to each other.
Companies typically peg their leveraged loans to a one-month or three-month contract, where they pay lenders Libor plus a set interest rate.
Concern about how to best handle the large spread differential between the two rates has weighed on market participants. Three-month Libor was set at 121bp on Thursday, while SOFR was set at 10bp.
“The absence of a term SOFR is a big concern right now because people don’t know what they are moving to,” said Kevin Grumberg, a partner at law firm Goodwin Procter. “One key reason people aren’t ready to commit is it doesn’t feel like an apple to apple switch.”
The move to a new reference rate by the end of next year was already considered a reach by many loan market participants. Now, with the asset class focused on the impact coronavirus is having on borrowers and the broader economy, the transition is even further from investment professionals’ minds.
The UK’s Financial Conduct Authority, which called for the December 31, 2021 deadline, and the Bank of England are assessing the impact coronavirus will have on meeting the transition date, Reuters reported last month.
“We just focus on the facts as we know them. Obviously anything can happen – these are very challenging times – but from the information that we have today, it remains clear that we should be going down the tracks by the end of 2021,” said Tom Wipf, vice chairman of institutional securities at Morgan Stanley and the chair of the Alternative Reference Rates Committee (ARRC), which is working on the transition. “There is work that we have underway during this period, and, as you can see from our recent announcements, we’ve been able to advance that work and will continue to do so.”
Concerns about the spread differential between Libor and SOFR have been at the heart of the transition debate.
While a difference is expected – as a risk-free rate, SOFR was always anticipated to be less than Libor – spikes in SOFR have caused alarm amongst investors already wary about the change. In September, SOFR rose to 525bp, significantly higher than three-month Libor, which sat at 216bp.
A spread adjustment was proposed. The Fed-backed ARRC suggested adding so-called fallback language to credit agreements including a hardwired approach that stipulates that when Libor is no longer viable, the benchmark will move to a forward-looking term SOFR rate plus a spread adjustment. If that was not possible, it will move to compounded SOFR plus a spread adjustment.
Last week the ARRC recommended a spread adjustment methodology for cash products based on a historical median over a five-year lookback period calculating the difference between Libor and SOFR, according to a news release.
“The critical juncture is in the spread adjustment, which will be the single value added to SOFR in every existing contract to make it the same as Libor,” said David Wagner, a senior advisor at Houlihan Lokey. “ARRC is dealing with this in the new guidance for cash products, but this is the area that risk managers need to watch for signs of value transfer at cessation.”
The ARRC announcement is positive news for the transition. On the one hand, it will provide more certainty of the spread methodology, and on the other, it will bring more visibility into the economics, said Meredith Coffey, executive vice president of the loan trade group, the Loan Syndications and Trading Association.
The International Swaps and Derivatives Association is set to begin publishing an indicative spread adjustment soon. Using the five-year range should offset any unexpected spikes or prolonged bouts of volatility, Coffey said.
“This crisis will provide more data on how SOFR and Libor behave in a crisis period, so that information will be helpful as we structure things going forward,” she said.
Still, adding to these challenges is the operational transition, so many institutions will need to address before 2021, which may make it more challenging to meet the Libor transition deadline in about 20 months.
“There was always skepticism about whether to take the (end of 2021) deadline seriously,” said Goodwin’s Grumberg. “Folks are now thinking more seriously that an extension will need to be contemplated.” (Reporting by Kristen Haunss and Michelle Sierra. Editing by Jon Methven)
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