The loan market struggles with the last days of Libor
Capital markets are used to change of all kinds, but it usually happens gradually. Never before has a crucial financial instrument – the backbone of billions of dollars worth of contracts – been destroyed overnight. However, this is what should happen on December 31, 2021, when the Libor dollar and pound sterling will cease to be calculated.
These interest rate benchmarks, critical to the corporate loan and swap markets since the 1980s, will disappear on the orders of the Bank of England, following traders’ illegal manipulation of the Libor peg in the mid-2000s.
Libor’s death date has been known since 2017, which should have given markets time to prepare, as ordered by regulators, for a move to risk-free rates based on actual transactions. This means the Secured Overnight Funding Rate (Sofr) for dollars, derived from US Treasury repos, and the Sterling Overnight Index Average (Sonia), based on unsecured interbank lending.
But while the Libor is a unique instrument, the process of its replacement has been handled separately, and very differently, by each market that uses it.
In the bond market, the issue has caused relatively little angst so far. New floating rate issues linked to Libor have largely, but not entirely, been replaced by bonds referencing Sofr and Sonia. Although not all investors like them, in 2020 9% of all dollar bond issues and 9.5% of sterling were floating rate.
One issue that will likely need work in 2021 is older hybrid equity securities that will reset to Libor-based rates if not called. Lloyds Bank was the first issuer to seek investors’ consent to change the terms of the risk-free rates and a few other issuers have followed suit, but there will be more to do. However, market participants are not worried about it.
The derivatives industry has also rebounded, thanks to the International Swaps and Derivatives Association, which drafts the standard contract used in almost all swaps. The ISDA fallback protocol will allow Libor-based contracts to be amended en masse in the fourth quarter of 2021, without the need for individual negotiations.
In the business loan market, it’s very different. Even though virtually all companies, regardless of size, have Libor-based loans, hardly any of them have taken steps to modify them. Not only that: they’re signing hundreds of new Libor-linked loans.
That means 2021 is going to be a mad rush of issuers downgrading their debt to risk-free rates, in a process known as repapering.
“There is a wave of repapering to be done,” says Nicolas Rabier, co-head of EMEA credit capital markets at BNP Paribas. “Even if you have no interest in fundraising in 2021, you still need to do something in your organization.”
Due to the legal structure of the loan market, each contract must be renegotiated separately.
“It’s not just about automatically changing the contract,” says Rabier. “It’s much more complex than cutting the Libor and putting in Sonia or Sofr. Each customer will have to accept the changes. We should expect active discussions.
These discussions will need to be nuanced and in-depth. “Using risk-free rates is fundamentally different from Libor – it requires a lot of fine-tuning,” says Natasha Vowles, head of treasury, finance at Tesco, one of the few companies to have changed its lending. “Libor was very borrower-friendly as a construction. It was quite difficult to understand how the new methodologies work. It made life more complicated. »
In an ideal world, issuers would come to their banks with transition requests at well-spaced intervals, giving lenders time to change sections of documentation. But if the coronavirus pandemic has taught the market anything, it’s that the world is unlikely to be ideal for some time.
“I expect bottlenecks from everyone rushing into the market at the same time,” says Rabier. “We will suddenly have a flow of requests. I don’t know if it will happen in the first quarter or if customers will wait until the end of the year, but next year will be very busy.
Even more problematic for a smooth transition from Libor is that there are few precedents to emulate. Data from the Loan Market Association released in October showed that, surprisingly, only 19 loans were signed and made public in Libor jurisdictions that reference risk-free rates.
Looking on the bright side, Clare Dawson, CEO of the LMA, says, “We have a lot of building blocks in place. One problem is that for borrowers it hasn’t been exactly a normal year [because of the pandemic] and they had many other challenges to overcome.
Lenders, on the other hand, remained focused on the issue. “Banks, despite their Covid relationship, have always continued to work on Libor,” she says. “People haven’t diverted their attention from that.”
Although concrete examples of what works are rare, there are some cornerstones to hold on to.
So far, most prime borrowers who have tackled the problem have structured Libor-based loans which will convert to risk-free rates from 2022. British American Tobacco has done this with a double tranche equivalent to £6 billion, signed in March.
GlaxoSmithKline went further in September by modifying the equivalent of £3.8 billion in bilateral loans to immediately cancel risk-free rates.
And in October, Tesco, the British supermarket chain, signed a new three-year multi-currency loan equivalent to £2.5 billion, based on risk-free rates from the outset. “We just decided to go for it,” says Vowles. “We expected a few more [companies] have taken the plunge, but this year has been difficult for many people.
Tesco’s loan is still based on Libor, but uses an adjustment spread to achieve risk-free rates. “We know that our loan will not be the end point. [in setting the standard] because we kept the credit spread adjustment,” says Vowles. “Ours is a stepping stone – you can’t wait for market standards to land, someone has to do something.”
Crucially, the Tesco loan had a full syndicate of 15 banks, unlike Glaxo’s bilateral facilities, so it better replicates what a functioning syndicated loan market will look like once Libor is removed.
“Most, if not all, of the banks are almost ready,” says BNP Paribas’ Rabier, bookrunner on the Tesco deal. “A lot of banks have systems in place to manage the rate.”
Not everyone is so confident that banks are ready to go now, especially when it comes to the systems needed. “[Lenders are] you don’t want to process all installations from a spreadsheet; they will want their systems to administer everything,” says Dawson.
Regardless of insurance, it’s hard to know exactly how prepared someone is until companies start using the new facilities. This is when spread calculations will be tested and money movements will show if the banking systems are up to the task.
“The proof will come with the first drawings,” says Rabier. “It will be a transition until March or June of next year. We will see a stabilization of the mandates at that time and that will give a little more confidence. »
Some market segments may not be able to put their processes in place on time. Regulators have a plan for this – sort of.
The UK’s Financial Conduct Authority will be given new powers in the Financial Services Bill introduced in Parliament in October, to compel the ICE Benchmark administration, which administers Libor, to continue publishing it after 2021, under certain circumstances and under a new methodology – to help those struggling with old Libor-based contracts.
For banks, calculating loan interest rates could be difficult to achieve in time, particularly if the market does not settle on a unified approach to the tricky mathematical equations needed to compensate for the slight difference between Libor and risk-free rate.
Despite the best efforts of the loan market working groups, the way to proceed is not settled. “There is still work for people to do in terms of active transitioning before the end of 2021,” says Dawson. “In other words, what are they doing in terms of the credit adjustment spread between the Libor and the risk-free rates?”
The Federal Reserve has also “made noise about a safety net … allowing certain products referencing Libor to reach maturity,” Padhraic Garvey, head of research for the Americas at ING, said in a statement. research note.
Difficult legacy contracts also affect derivatives, especially when hedging a difficult legacy loan.
ISDA has a solution for this. Its protocol creates a fallback rate for Libor contracts by default when Libor is no longer: the risk-free rate, plus the five-year median difference between it and Libor.
Nevertheless, this remains a marginal concern, and like much of the transition from Libor to lending, mostly hypothetical so far.
However, the more deals signed using risk-free rates, the easier and quicker the transition will become, like a snowball accelerating as it descends.
“As more deals were made, as we released more documents, and as people studied them and used them in deals, we got a lot of feedback,” Dawson says.
The loan market, however, may see the snowball turn into an avalanche. gVS