LIBOR is dying. UK regulators announced last week a 5 year plan to phase the controversial and flawed rate. It will be replaced. By what and when is a matter of debate and speculation at this time, but changes are afoot.
So what does this mean for the more than multi-trillion dollar bank loan market? Stephen Hazelton, Founder and CEO of Street Diligence, a leading fixed income analytics platform explores the potential impact.
Bank loan credit agreements have, for decades, relied on LIBOR to price interest rate payments. Typically, interest payments have been based on LIBOR plus a risk premium. With last week’s announcement that LIBOR will disappear and be replaced by 2021, we are set to see significant change. Though status quo will rule the day in the short term, the changes may come sooner than many anticipate.
The Mechanics: Pricing off of LIBOR (the London Interbank Offer Rate) is the overwhelming standard in bank loans, including but not limited to revolving credit facilities and term loans. A loan will usually pay interest quarterly based on an “Applicable Rate,” comprised of the greater of 1) LIBOR plus a risk premium or 2) a minimum interest rate floor (usually 1%). Thus, as LIBOR fluctuates, the interest due on a particular loan does as well, providing lenders protection in a rising interest rate environment. Traditionally, this floating rate protection has been a significant differentiator for bank loans as comparison to fixed rate corporate bonds, and is particularly attractive in the low interest rate environment we’re currently in.
Manipulation: The manipulation of LIBOR has been well documented and is not the focus of this piece. That said, it is important to understand the basis of the rate and it weakness. LIBOR is based on estimates, not actual transactions, submitted by banks for interest rates they would be willing to pay other lending institutions for borrowings of varying terms and in numerous currencies. The key here is that the estimates are not actionable, and thus subject to manipulation for the benefit of conflicted parties at the participating banks.
The Changes: These loans typically mature in five or six years, meaning the phase out period for the LIBOR rate is a near term issue for any new issuances. Lenders and borrowers, and by extension their attorneys and underwriters, will have to consider the alternatives in the coming weeks and months. Waiting until the rate phases out and sunsets will necessitate marketing a loan with some level of uncertainly on the back end, an unappealing and unlikely scenario. Thus, loan markets will adjust and likely replace LIBOR well in advance of its official phase out date.
A Replacement: There are a number of options to LIBOR, some of which are better than others. The likely winner, or winners, may well be an upgrade from LIBOR and may also require geography-specific solutions. For instance, one initiative in the UK, which is supported by a number of global banks, proposes the use of the Sterling Overnight Index Average, or SONIA, a measure of Sterling-denominated overnight funding rates from actual transactions in the wholesale money markets. While this eliminates the reliance on estimates, the frequency of transactions is an open question. Often times, interbank lending transactions are not frequent enough across the spectrum of short term periods to represent a credible, liquid view of market rates at any given time and across currencies. In times of market stress, as we experienced during the recent financial crisis, credit markets can dry up completely, leaving rates in limbo.
The crux of the matter lies in liquidity and choice of currency. Interbank lending transactions, which in theory represent a close measure of a near risk-free rate, have declined since the financial crisis. In the US, the Overnight Bank Funding Rate (OBFR) and the overnight lending rate in US Treasury-backed repurchase “repo” agreements are two leading alternatives. The OBFR is based on a weighted-average, overnight federal funds rate for unsecured, dollar and Eurodollar, loans. The overnight lending rate, in contrast, is secured by Treasuries to backstop the loans. Other markets developing similar alternatives include the Swiss, Japanese and Euro markets.
Bottom Line for Bank Loans: For stakeholders in bank loans, the new benchmark will likely consist of several alternatives, based on actual transactions. Will arbitrage opportunities or drawbacks arise due to the lack of a frequent, reliable volume of transactions underpinning the new benchmark? That’s unlikely, particularly given the block size and illiquid nature of bank loans. The process of amending existing loans to reflect the new benchmark will, however, be an interesting and potentially difficult process. Most agreements allow for successor rates to be adopted, but language varies, leaving a potential for conflicting interests particularly in multi-currency or cross-border paper.
What’s certain is that borrowers and lenders will begin the slow process of transitioning to the new rate(s), including an adjustment to managing their portfolio of loans based on a multi-currency risk profile, rather than a single, LIBOR-based profile. In the medium term, the transition will keep attorneys busy advising and amending credit agreements outstanding in the marketplace to reflect the new benchmark.