The Clock Is Ticking on Libor: What It Means for US Syndicated Loans and CLOs

Author:
Kevin Wolfson
Portfolio Manager, US Leveraged Loans

9 March 2020
  • The London Interbank Offered Rate (Libor), the most widely referenced short-term interest rate in the world, is set to be phased out after 2021 owing to concerns about its subjectivity.
  • Given the magnitude of financial contracts tied to US Libor, the Federal Reserve has tasked the Alternative Reference Rates Committee (ARRC) with transitioning US markets to its recommended alternative benchmark, the Secured Overnight Financing Rate (SOFR).
  • A few key issues have yet to be addressed that may hinder progress toward the transition, including disparities between the two benchmarks’ credit risk economics (and the need to finalize an appropriate credit spread adjustment), SOFR’s lack of a term structure, and the lack of uniformity in loan documentation related to the benchmark update.
  • Given these hurdles, we continue to favor a flexible approach and note that while we don’t expect the transition to be seamless, we think the likelihood of a systemic failure is minimal.

The London Interbank Offered Rate (Libor), the most widely referenced short-term interest rate in the world, may cease to exist after 2021. Libor represents the average interest rate major banks charge one another for an unsecured loan over a specified term in a specific currency, and it serves as the reference rate for an estimated $200 trillion in transactions globally.1 This includes the roughly $1.2 trillion US syndicated loan market and the more than $600 billion US collateralized loan obligation (CLO) market.2

Despite its widespread use, ongoing concerns about the subjectivity of Libor – which lacks an active underlying market and relies on banks’ reporting (including an “expert judgment” component) to set the daily benchmark – have driven a push to retire Libor. To this end, the UK Financial Conduct Authority (FCA) will no longer compel banks to submit the surveys used to determine Libor after 2021, and financial markets are preparing for the transition to new benchmarks as replacement rates are finalized.

Here we discuss Libor’s role, its complex transition, and, critically, the investment implications for US syndicated loans and CLOs. While we believe markets will ultimately weather the transition to new benchmarks, there is still work to be done – and market participants should not be complacent.

Libor’s likely US replacement – SOFR – and how it differs

Given the magnitude of financial contracts tied to US Libor, the Federal Reserve has tasked the Alternative Reference Rates Committee (ARRC) with transitioning markets to its recommended alternative benchmark, the Secured Overnight Financing Rate (SOFR). Unlike Libor, which has essentially become a hypothetical rate, SOFR is calculated using real market transactions and benefits from significant liquidity and ample market depth. We note that while SOFR is the preferred successor rate for US dollar Libor transactions, other countries and regions have introduced their own preferred successor rates for non-US-dollar transactions.

The Libor Transition: Different Countries Plan for Their Own Successor Rates

Country/Region Libor Replacement Rate
Eurozone Euro Short-Term Rate (€STR)
Japan Tokyo Overnight Average rate (TONA)
Switzerland Swiss Average Rate Overnight (SARON)
UK Sterling Overnight Index Average (SONIA)
US Secured Overnight Financing Rate (SOFR)

Source: Financial Conduct Authority as of 27 February 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Two key disparities between Libor and SOFR that will need to be addressed during the transition relate to credit risk economics and the lack of a term structure for SOFR.

While Libor is an unsecured rate and reflects bank credit risk, SOFR is based on underlying repo transactions collateralized by US Treasuries, making it a near risk-free rate. Accordingly, SOFR is likely to offer a lower spread than the Libor equivalent. This means a spread adjustment will be needed to ensure comparability between the benchmark rates, as well as to reduce the potential for value transfer between borrowers and lenders.

Given that a dynamic spread adjustment based on the difference between Libor and SOFR is not an option with Libor’s eventual cessation, the ARRC is contemplating the use of a static spread adjustment that looks back at the historical differences between the two rates. However, such a static adjustment may not adequately account for Libor’s volatility and could thus lead to increased credit spread volatility. As such, a more dynamic alternative may need to be considered. Irrespective of the spread adjustment methodology the syndicated loan market eventually embraces, we are encouraged to see that market participants are actively contemplating the benefits and risks of potential alternatives.

Additionally, while Libor is available in a variety of tenors, SOFR is an overnight rate and currently lacks the term structure needed to work for certain financial contracts. A robust SOFR futures market is essential for the development of term SOFR, and although a market has begun to develop, it lacks the liquidity necessary to determine an adequate term structure. While SOFR may evolve to include rates at various tenors, alternatives such as compounded SOFR, though not ideal, are currently available in case such developments do not occur before Libor is phased out.

Implications for the US syndicated loan market

The lack of adequate fallback language to address the likely discontinuation of the benchmark rate remains an issue for US syndicated loan contracts. Current documentation will need to be updated to incorporate 1) guidelines for the transition from Libor to a new reference rate, 2) triggers to effectuate the transition, and 3) the methodology used to calculate the stated reference rate, including any necessary spread adjustments.

While loan credit agreements have historically incorporated fallback guidance, they frequently revert to an alternate base rate (ABR) if Libor quotes are no longer available. This ABR is often defined as the higher of several options, including the prime rate and the federal funds rate plus 50 basis points (bps).3 As these ABRs do not approximate Libor and would necessitate a material shift in economics if they were to become effective, the ARRC recognizes the need to incorporate new fallback language into many credit agreements.

As noted above, we believe loan credit agreements need to include language specifying either SOFR or some other preferred successor rate. ARRC suggests two potential solutions – the amendment approach or the hardwired approach – both of which would be subject to predefined trigger events to prompt the change.

Although SOFR currently is the preferred successor rate, the amendment approach does not specifically identify SOFR, instead providing more flexibility in case a different successor rate emerges. If a triggering event were to occur, the agent bank would notify lenders of the rate change via a “negative consent” process; in other words, unless a majority of lenders object, the new successor rate would become effective once a certain period of time had elapsed following the notification.

Conversely, the hardwired approach would designate term SOFR as the primary preferred successor rate in credit agreements. However, it would also incorporate language for the use of compounded daily SOFR as needed if term SOFR does not exist at the time of the transition. Similar to the amendment approach, the hardwired approach would include language allowing for a smooth transition to an alternative rate if SOFR is not the successor.

Each approach has merits and drawbacks. The amendment approach allows for greater flexibility but lacks the clarity of the hardwired approach (and vice versa). The amendment approach could also create winners and losers depending on the timing of the transition; both borrowers and lenders could use this flexibility to negotiate additional economics depending on the relative strength or weakness of the market or credit. As each situation is unique, we expect market participants to use a combination of both approaches. Regardless of which they choose, it’s important that credit agreements are amended prior to a triggering event to avoid placing administrative stress on the system at a single point in time.

Implications for the US CLO market

With CLOs representing a significant source of demand for US syndicated loans, the technicals of these markets are distinctly interconnected. CLO arbitrage and payment waterfalls are dependent on the matching (or near matching) of reference rates between assets and liabilities. In order to reduce basis risk, it’s therefore critical that a CLO indenture consider not only the amendments needed to smoothly transition the reference rate of its liabilities, but also the timing of the changes in the reference rate of its assets (i.e., loans).

Since the FCA’s July 2017 announcement on the future of Libor, most CLO indentures have incorporated language in some form to facilitate an orderly transition away from Libor. However, in May 2019 the ARRC formalized its recommended fallback language for securitizations. If implemented, such language will allow for a change in the reference rate as long as one of several triggers is satisfied. Among the recommended triggers are 1) a public announcement that Libor will cease to be published by Libor’s administrator, the FCA, the Fed, or some other authority with jurisdiction over the administrator; and 2) use of the new reference rate by more than 50% of the underlying loans within the CLO (either of which would independently trigger the change).

CLOs that predate the FCA announcement or that have not been modified with applicable fallback language will likely require an amendment; otherwise, their reference rate will likely eventually revert to the last available Libor value. Each CLO indenture is unique, so the requirements to facilitate an amendment will likewise vary. We estimate that the majority of outstanding CLOs were either issued, reset, or refinanced after December 2017 and therefore likely contain some form of improved fallback language versus older-vintage transactions. As time passes and older-vintage CLOs are either called or refinanced, the percentage of outstanding deals that require an amendment will continue to shrink.

Key takeaways for loan and CLO investors

With the likely phase-out of Libor less than two years away, market participants have a clear incentive to coordinate their efforts to minimize disruptions in both the US loan and CLO markets. Given the need for a measured transition, both the ARRC and the Loan Syndications & Trading Association (LSTA) have been proactive about moving the process forward. Nonetheless, the lack of uniformity in loan documentation, the preference for developing term SOFR, and the need to finalize an appropriate credit spread adjustment are hindering progress. Given these hurdles, we continue to favor an approach that maintains flexibility.

The syndicated loan market has successfully adapted to changes in the past, and we believe the Libor transition is another step in the market’s evolution. Although investors should not expect a seamless transition, we believe the likelihood of a systemic failure is minimal. SOFR remains well positioned to be the eventual replacement for Libor, although investors need to be cognizant of the challenges that remain and the possibility that other replacement rates may ultimately emerge.

Footnotes

1The Alternative Reference Rates Committee’s Second Report March 2018 (figures estimated from end of 2016).
2S&P Global Market Intelligence (LCD) as of 31 January 2020 for syndicated loans; SIFMA as of 31 March 2019 for CLOs.
3The Alternative Reference Rates Committee’s recommendations as of 25 April 2019 are accessible at: https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/Syndicated_Loan_Fallback_Language.pdf.