FIXED – Coronavirus pandemic could transition the loan market from Libor. slow it down
(Corrects April 13th story to change SOFR in fifth paragraph from 10bp to 1bp)
NEW YORK, April 22nd (LPC) – A health emergency of unprecedented proportions has marked the transition of the U.S. credit market away from a major credit benchmark used to set interest payments on trillions of dollars in investment as the deadline for the transition, made even more complex a new rate is rapidly approaching.
Companies like General Electric, General Motors and American Airlines tie part of their loan interest payments to the London Interbank Offered Rate (Libor). After interest rate scandals over the major financial crisis, a UK regulator said markets should move to a new benchmark for lending by the end of 2021.
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 overnight backed by US Treasuries. The Libor is an average interest rate that banks say they would charge each other to borrow.
Companies usually tie their leveraged loans to a one-month or three-month contract in which they pay the lenders the Libor plus a fixed interest rate.
Concerns about how best to handle the large spread difference between the two rates have weighed on market participants. The three-month Libor was fixed at 121 basis points on Thursday while the SOFR was fixed at 1 basis point.
“The lack of a term SOFR is a big problem right now because people don’t know where to go,” said Kevin Grumberg, partner at Goodwin Procter law firm. “One of the main reasons people aren’t ready to get involved is because it doesn’t feel like switching from apple to apple.”
The conversion to a new reference interest rate by the end of next year has already been viewed by many credit market participants as having been achieved. With the asset class now focused on the impact of the coronavirus on borrowers and the economy in general, the transition is even further removed from the minds of investment professionals.
The UK’s Financial Conduct Authority, which has requested the December 31, 2021 deadline, and the Bank of England are assessing the impact of the coronavirus on compliance with the transition date, Reuters reported last month.
“We only focus on the facts as we know them. Of course anything can happen – these are very challenging times – but from the information we have today, it is clear that we should be on the trail by the end of 2021, ”said Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley and the Chair of the Alternative Reference Rate Committee (ARRC) working on the changeover. “During this period we have work in progress and as you can see from our recent announcements, we have been able to and will continue to move forward with that work.”
EVALUATE THE DEBATE
Concerns about the spread difference between Libor and SOFR were at the center of the transition debate.
While a difference is expected – as a risk-free rate, the SOFR has always been expected to be lower than the Libor – the spikes in the SOFR have raised concerns among investors already skeptical about the change. In September the SOFR rose to 525 basis points and was thus well above the three-month Libor, which was 216 basis points.
A spread adjustment was proposed. The Fed-backed ARRC proposed adding something called fallback language to loan agreements, including a hard-wired approach that would see the benchmark transition to a forward-looking SOFR rate plus a spread adjustment when the Libor is no longer profitable. If this was not possible, a composite SOFR plus spread adjustment is used.
Last week, according to a press release, the ARRC recommended a spread adjustment method for spot products that is based on a historical median over a five-year look-back period and calculates the difference between Libor and SOFR.
“The critical point is the spread adjustment, which will be the only added value for SOFR in any existing contract to make it equal to the Libor,” said David Wagner, Senior Advisor at Houlihan Lokey. “ARRC is addressing this in the new guidelines for cash products, but this is the area risk managers need to look out for when hiring for signs of value transfer.”
The ARRC announcement is positive news for the transition. On the one hand there will be more certainty with the spread methodology and on the other hand it will bring more transparency to the economy, said Meredith Coffey, executive vice president of the Loan Trade Group, the Loan Syndications and Trading Association.
The International Swaps and Derivatives Association will shortly begin publishing an indicative spread adjustment. Using the 5-year range should offset unexpected spikes or prolonged surges in volatility, Coffey said.
“This crisis will provide more data on how SOFR and Libor behave in a time of crisis, so information will be helpful in structuring things in the future,” she said.
In addition to these challenges, however, there is the operational transition that many institutions have to tackle before 2021, which could make it more difficult to meet the transition period for the Libor in around 20 months.
“There was always skepticism about whether the deadline (end of 2021) should be taken seriously,” said Goodwin’s Grumberg. “People are now more seriously thinking that an extension should be considered.” (Reporting by Kristen Haunss and Michelle Sierra. Editing by Jon Methven)