FIXED – Coronavirus Pandemic May Slow Loan Market Transition from Libor
(Corrects April 13 story to change SOFR to 1bp from 10bp in fifth paragraph)
NEW YORK, April 22 (LPC) — A health emergency of unprecedented scale has added another layer of complexity to the U.S. lending market’s transition away from a key lending benchmark used to set interest payments on trillions of dollars of investments as the deadline to shift to a new pace is fast approaching.
Companies such as General Electric, General Motors and American Airlines all tie a portion of their loan interest payments to the London Interbank Offered Rate (Libor). Following rate-related scandals resulting from the Great Financial Crisis, a UK regulator has said that by the end of 2021, markets are expected to move to a new lending benchmark.
A Federal Reserve (Fed)-backed group has recommended moving to the Secured Overnight Funding Rate (SOFR), a large measure of the cost of overnight cash borrowing backed by US Treasury securities. Libor is an average rate that banks say they charge to lend to each other.
Firms typically peg their leveraged loans into a one-month or three-month contract, where they pay lenders Libor plus a fixed interest rate.
Concerns about how best to manage the large spread gap between the two rates weighed on market participants. The three-month Libor was pegged at 121bp on Thursday, while SOFR was pegged at 1bp.
“The lack of a SOFR term is a big concern right now because people don’t know what they’re headed for,” said Kevin Grumberg, partner at law firm Goodwin Procter. “One of the biggest reasons people aren’t ready to commit is that it doesn’t feel like an apple-to-apple change.”
Switching to a new benchmark rate by the end of next year was already seen as a reach by many players in the lending market. Now, with the asset class focused on the impact of the coronavirus on borrowers and the wider economy, the transition is even further 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 the coronavirus will have on meeting the transition date, Reuters reported last month.
“We only focus on the facts as we know them. Obviously anything can happen – these are very difficult times – but based on the information we have today, it remains clear that we should be back on track by the end of 2021,” said Tom Wipf, Vice President of Institutional Securities at Morgan Stanley. and the chair of the Alternative Reference Rates Committee (ARRC), which works on the transition. “There is work we have going on during this time and as you can see from our recent announcements we have been able to move that work forward 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 has always been expected to be lower than Libor – SOFR’s spikes have alarmed investors already wary of the change. In September, SOFR rose to 525 bps, significantly above the three-month Libor, which stood at 216 bps.
A gap adjustment was proposed. The Fed-backed ARRC has suggested adding so-called fallback language to credit agreements, including a hard-wired approach that states that when Libor becomes unviable, the benchmark will move to a SOFR rate. forward-looking forward plus a spread adjustment. If this was not possible, it will switch to compound SOFR plus a spread adjustment.
Last week, the ARRC recommended a spread adjustment methodology for spot products based on a historical median over a five-year look-back period calculating the difference between Libor and SOFR, according to a press release.
“The critical moment is in the adjustment of spreads, which will be the only value added to SOFR in every existing contract to make it identical to Libor,” said David Wagner, senior adviser at Houlihan Lokey. “The ARRC addresses this in the new guidance for treasury products, but this is the area that risk managers need to watch for signs of value transfer on termination.”
The ARRC announcement is good news for the transition. On the one hand, it will provide more certainty about the spread methodology and, on the other hand, it will bring more visibility on the economy, said Meredith Coffey, executive vice president of the loans trade group, the Loan Syndications and Trading Association.
The International Swaps and Derivatives Association is expected to start 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 times of crisis, so that information will be useful in structuring things going forward,” she said.
However, the operational transition adds to these challenges, so many institutions will need to tackle it before 2021, which could make it more difficult to meet the Libor transition deadline in around 20 months.
“There was always skepticism about whether to take the deadline (end of 2021) seriously,” Grumberg said of Goodwin. “People now think more seriously that an extension will have to be considered.” (Reporting by Kristen Haunss and Michelle Sierra. Editing by Jon Methven)