Libor transition adds to loan market’s relentless struggles
Battling against falling volume, the loan market also has to work out how to replace Libor. Loan market life will surely get more stressful as the clock ticks down to December 2021, when the rate is due to be phased out, although distractions might come in the form of sustainability-linked structures, writes Mariam Meskin
The loan market faces its largest and most challenging transformation for decades: the elimination of the scandal-hit Libor (the London Interbank Overnight Rate), the benchmark rate for more than $300tr of financial products, from derivatives to loans to bonds, across the world.
Two years have passed since Andrew Bailey, chief executive of the UK Financial Conduct Authority, announced the planned phasing out of Libor by the end of 2021. Yet little progress has been made in the syndicated loan market to install a universally accepted alternative. The clock is ticking, as trade associations and banks search for the loan market’s golden ticket: how to tease a forward-looking term rate out of a backward-looking overnight risk-free benchmark.
As it stands, the transition away from Libor is set to put yet another obstacle in the way of banks trying to grow their lending in coming years. The challenge overwhelmed them in 2019 as investment grade loan volumes in Europe fell drastically. The year looks likely to end up as the quietest for the market since 2003, according to Dealogic figures that include all deals, not just those that are fully syndicated. Using bookrun deals only, it is likely to be the second or third worst year since 1998. By November 11, there had been $543bn of deals, down 24% from $710bn in the same stretch of 2018.
Agent banks’ to-do lists will be far longer and more complicated post-Libor, bankers predict. In dual currency deals, the sizes of euro and sterling tranches may need to be set from the beginning to make the transition easier for lenders to process, removing the flexibility that many companies turn to the loan market for. Transactions that can be drawn in different currencies — for example, in euros and later in sterling — will be more complicated for agents as they co-ordinate with lenders, calculate backward and forward-looking rates, and work out potential changes to tenor, and more.
“The market will roll back 30 or 40 years, to when single‑currency, bilateral deals were the default product,” says Sarah Boyce, associate director, policy and technical at the Association of Corporate Treasurers in London.
The likelihood of multi-currency transactions dwindling is a growing concern. Lenders have long prided themselves on offering borrowers as much flexibility as possible in lieu of other benefits more commonly found in the bond market, such as longer tenors.
“It is probably going to be increasingly complicated to run a multi-currency deal as we move away from Libor,” says Clare Dawson, chief executive of the Loan Market Association in London. “Borrowers will have to get their heads around Euribor existing alongside another potential benchmark for their dollar or sterling funding.”
Laurent Vignon, head of EMEA loan syndicate at Société Générale in Paris, agrees. “Calculating the different margins for each currency on a multi-tranche revolver will be more complex than before, given the different nature of the new benchmark rates (i.e., term rates versus overnight, secured versus unsecured) and the different times of publication of the benchmarks. The single currency documents are less of a concern.”
The uncertainty around the transition may push even more borrowers into the bond market, a trend that was in clear evidence in 2019. “Borrowers could possibly be put off from the loan market amid the transition disruption, particularly smaller, less sophisticated companies in the midcap space — the systems are not in place to switch over existing loans yet,” adds Vignon.
Reluctance turns to acceptance
Sonia, the Sterling Overnight Index Average, is the Bank of England’s preferred ‘risk-free’ interest rate benchmark to replace Libor.
However, some participants have resisted adopting it –– because it is backward-looking — and are insisting on a forward-looking term rate. Sonia supporters advocate compounding the rate to simulate the upward-sloping shape of a term curve.
“Some borrowers see Sonia as a workable alternative and may decide that compounding in arrears may work for them, but others want a forward-looking rate,” says Dawson.
“But I do not see how you could use anything other than a forward-looking rate in a trade finance deal based on discounting, for example. There will not just be one solution used by everybody.”
Associated British Ports captured the attention of lenders in May and June 2019 when it obtained bond investors’ consent to switch an existing £65m floating rate note to Sonia. Though that move was considered a feat, it highlighted the lack of preparedness in the loan market. “We are comfortable with raising a Sonia-linked syndicated loan now — but it is the banks that aren’t ready to lend,” says Shaun Kennedy, group treasurer of ABP. “Their internal systems aren’t ready for the transition, and that is what is holding issuance back. Once they sort themselves out, we will enter the market.”
The Libor transition has put a hold on some borrowers’ plans. “The uncertainty around Libor has certainly held some corporates back from doing more in the loan market,” Kennedy adds.
Though lenders are eager to do what they do best — lend — a Sonia-linked syndicated loan remains in the future. Libor continues to dominate transactions.
“Banks are not refraining from signing loans linked to Libor — there is caution around banks individually deciding on a replacement without a consensus on a new benchmark, but banks are still ready to lend,” says Jon Abando, managing director in loan capital markets at JP Morgan in London.
The transition away from Libor is making more progress in the bilateral lending market, where National Express raised the first Sonia-linked loan through NatWest in June. “We took the view that this would enable us to fully understand Libor transition and have an active say in how the marketplace develops, without exposing ourselves to too much risk,” says David Daniels, group treasurer at National Express.
But the difficulties of linking even a bilateral loan to an overnight rate do not bode well for Sonia becoming the benchmark in the syndicated market.
“Being the first to market always comes with its challenges,” says Daniels. “In the absence of final guidance from ISDA [the International Swaps and Derivatives Association] or the LMA, few IT providers have updated their systems and so booking and confirming the loans have been a challenge. We had to build our own ‘five-day compounding in arrears’ spreadsheet model to validate the bank’s quoted rate — in fact we managed to get the bank to amend their calculations when we identified they had a rounding issue. Additionally, accruals over a period end have been calculated manually as the rate is not finalised until a week before maturity.”
Trouble after trouble
Lenders are questioning what will happen to pricing after the computation of interest has been agreed for a new benchmark rate. “The pricing on a sterling deal linked to Libor today will be different on the same deal but linked to Sonia, as the internal refinancing costs of a lender vis à vis the benchmark rate will be different,” says Vignon of Société Générale.
But finding a new alternative and figuring out pricing are not the only burdens on lenders’ shoulders — they will also need to grapple with the logistical mountain of adjusting their legacy books of billions of dollars worth of Libor-linked loans. Some are looking into artificial intelligence to aid the process, but the colossal scope of the shift threatens to swamp syndicated loan desks worldwide.
“It looks extremely difficult, if not impossible, to come up with a solution to transfer loan contracts from Libor to a risk‑free rate wholesale in batches, and then be confident that everyone would sign up to it,” says Dawson. “It is very likely that loans will have to be amended on an individual contract basis.”
Though some banks have already begun amending some documentation, a market-wide move away from Libor cannot be comprehensively done until participants are comfortable with a new benchmark.
“There will be a significant amendment and repapering process, and inevitably it will be a tremendous drain on resources,” says Paul Gibbs, managing director, loans and acquisition finance at Citigroup in London.
And time is passing. Though the market is working overtime to figure out the transition, the Bank of England warned markets in October that more needed to be done to prepare for the end of Libor, due by December 2021 in the UK and the US.
Lenders know they need to hurry. “There is still time to address these industry-wide issues and develop solutions, but the pace needs to be picked up with the transition,” says Abando. “It needs to be broadly discussed in open forums. We will see an acceleration of work around the transition in 2020.”
Back to 2003
The stressful move away from Libor coincides with a tough period in Europe’s investment grade loan market. Loan markets have contracted globally in 2019, thanks to a lower than expected volume of mergers and acquisitions and political uncertainty, including international trade disputes and Brexit.
But for lenders in Europe, the situation has been made worse by global interest rates declining and the European Central Bank restarting its quantitative easing programme, which has made the bond market increasingly attractive to borrowers. And that is not set to change any time soon, much to lenders’ dismay.
“There is no rosy outlook for 2020, and therefore some companies will continue to hold back, not on the revolving credit facilities or refinancings, but on their mergers or jumbo deals,” says Matthias Noack, co-head of debt capital markets, loans and bonds at MUFG in London. “We will most likely see volumes remain flattish or slightly decreasing.”
Investment grade lending in Europe declined sharply in 2019. By mid-November the total of signed deals was 24% below that point in 2018.
“Geopolitical uncertainty made it difficult for borrowers to navigate the market this year,” says Gibbs at Citi. “With trade war headwinds and Brexit uncertainty, it is unsurprising that volumes have declined and M&A has not reached the levels we hoped for.”
What M&A there has been has been well supported, even in the UK. The love triangle between Prosus, Takeaway.com and Just Eat, which surfaced in October when the first two, both Dutch firms, made rival bids to acquire the latter, a UK takeaway ordering service, signals that there is still confidence in UK markets. But the noticeable absence of big mergers has severely disappointed lenders on the search for juicy business.
“The lack of M&A in 2019 continued to pose a challenge to the loan market,” says Noack. “In recent years, M&A constituted up to 40%-50% of the overall market; this year it was simply a fraction of overall volumes.”
The volume of loans raised in 2019, up to November, to finance mergers or acquisitions in Europe stands at $117bn, down 48% from last year, although the number of deals has fallen less, from 135 to 104. One of them was a $13.5bn bridge loan raised by the London Stock Exchange from a consortium of the market’s top lenders for its acquisition of Refinitiv.
The market’s depression has been exacerbated by a fall in refinancing activity, after borrowers rushed to get business done in the early years of soft monetary conditions. “The low interest rate environment has been clear for quite a while, so many corporates took advantage of conditions to refinance in earlier years,” says Laurent DeRoy, global head of loan distribution at Crédit Agricole in London. “But margins are still tight and there is plenty of liquidity in the IG market.”
Even midcaps have failed to offer much solace. “We have seen some small and medium-sized corporates in the crossover space, which would have perhaps gone to the loans market in previous years, now issuing bonds,” says Vignon. “Even double-B rated names can now get very favourable conditions in the bond market because spreads have come in.”
Bankers believe 2020 could be even leaner. In a poll taken at the LMA’s annual syndicated loans conference in September, no less than 50% of delegates predicted EMEA volumes would decrease by more than 10% over the next 12 months. Another 36% thought they would remain “rather unchanged”. Some were more optimistic; DeRoy expects a 10% increase on 2019.
Green the new black?
One part of the market that is generating hope and excitement among bankers is loans linked to environmental, social and governance (ESG) criteria.
Since the first sustainability-linked loans (SLLs) hit the European syndicated market in 2017 — deals for Unibail-Rodamco and Philips came in the same week in April that year — ESG-linked loans have been gathering momentum and sparking life into what is historically one of the more traditional and slow-moving financing markets.
Green and sustainability-linked loans swelled in 2019 to a remarkable 72 deals by November, totalling $62bn — 11% of loans signed in Europe in 2019. Optimism about the product’s trajectory is abundant.
German energy company E.On raised a €3.5bn sustainability-linked facility in October. The margin can be varied according to its ESG performance, as determined by ratings agencies including Sustainalytics.
Prada, the Italian fashion house, signed a €50m five year SLL in November, a first for the luxury goods industry, through Crédit Agricole. The margin will fall if Prada hits certain sustainability targets, such as a certain number of stores being assigned a LEED Gold or Platinum certificate; employees completing a number of training hours; and the company using Re-Nylon, a sustainable substitute for nylon.
“Sustainability-linked loans will be the area of the loan market where we see a lot of growth, despite the market still being in its infancy,” says Gibbs at Citi.
European lenders are confident that green and sustainability-linked financing will soon extend to all corners of the corporate market. “In most of our discussions with our large clients, and now with mid-caps too, there is always a discussion about sustainability-linked loans,” says Vignon. “Not all do it, but all are asking about it.”
In March 2019, the European, US and Asia Pacific loan associations issued Sustainability-Linked Loan Principles, in a bid to guide and stimulate issuance. But some say hindrances remain, for both lenders and borrowers.
“The pricing differential is currently less meaningful when you are only going up or down by 2.5bp on the margin,” says Gibbs. “The evolution of the product lies in the question: should the pricing differential be more beneficial, and also more punitive, to the borrower as targets are met or missed?”
Vignon at SG agrees and says banks might need help from their regulator to grow the market further. “Margins in the IG market are already extremely thin,” he says. “A tightening of 2.5bp is significant when initial margins are 17.5bp-20bp. In order for this sustainability margin improvement to grow, banks would need to get a benefit on the liability side, which they don’t have for the time being. There is talk that the ECB could provide incentives to banks to do more green/sustainable business, for example by providing those banks with better refinancing costs or a reduced capital allocation, but nothing is expected in the near future.”GC