Loan market wrestles with the last days of Libor
The death knell has sounded for Libor and the ubiquitous benchmark is entering its last year of existence. But while some market segments have set their houses in order for the change, the loan market has barely begun. Europe’s bankers expect an onslaught of borrowers switching their documents to new rates at the same time. Mike Turner reports
Capital markets are used to change of all kinds, but usually it happens gradually. Never before has a crucial financial instrument — the backbone of trillions of dollars of contracts — been destroyed overnight. Yet that is what is set to happen on December 31, 2021, when dollar and sterling Libor cease to be calculated.
These interest rate benchmarks, critical to both the corporate loan and swaps markets since the 1980s, will disappear by order of the Bank of England, as a consequence of the illegal manipulation of Libor setting by traders in the mid-2000s.
Libor’s death date has been known since 2017, which should have given markets time to prepare, as regulators ordered, for a switch to risk-free rates based on actual transactions. This means the Secured Overnight Financing Rate (Sofr) for dollars, drawn from US Treasury repos, and the Sterling Overnight Index Average (Sonia), based on unsecured interbank loans.
But although Libor is a single instrument, the process of replacing it 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. Floating rate new issuance linked to Libor has largely, though not entirely, been replaced with bonds referencing Sofr and Sonia. Although not all investors like them, in 2020 9% of all dollar bond issues and 9.5% of those in sterling have been floating rate.
One issue that is likely to require work in 2021 is older hybrid capital securities which will reset to Libor-based rates if they are not called. Lloyds Bank was the first issuer to solicit investors’ consent to change terms to risk-free rates and a few other issuers have followed, but there will be more to do. However, market participants are not worried about it.
The derivatives industry has also got its act together, thanks to the International Swaps and Derivatives Association, which writes the standard contract used in almost all swaps. ISDA’s fallback protocol will allow Libor-based contracts to be changed en masse in the fourth quarter of 2021, without the need for individual negotiations.
In the corporate loan market, it is very different. Even though virtually every company of any size has Libor-based loans, hardly any of them have taken steps to change them. Not only that: they are signing hundreds of new Libor-linked loans.
This means that 2021 is going to be a mad rush of issuers transitioning 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 loan capital markets EMEA at BNP Paribas. “Even if you have no interest in raising funds in 2021, you still need to do something in your organisation.”
Because of the legal structure of the loan market, every contract must be renegotiated separately.
“It’s not a question of just changing the contract automatically,” says Rabier. “It’s much more complex than cutting out Libor and putting on Sonia or Sofr. Each customer will have to embrace the changes. We should expect active discussions.”
These discussions will need to be nuanced and expansive. “Using risk-free rates is fundamentally different from Libor — it does take a lot of adjustments,” says Natasha Vowles, head of treasury, funding, at Tesco, one of the few companies that has switched its loans. “Libor was very borrower-friendly as a construct. It has been quite a challenge to grapple with how new methodologies work. It has made life complicated.”
In an ideal world, issuers would come to their banks with transition requests at nicely spaced out intervals, giving lenders time to amend the swathes of documentation. But if the coronavirus pandemic has taught the market anything, it is that the world is unlikely to be ideal for some time.
“I do expect bottlenecks of everyone rushing to the market at once,” Rabier says. “We will suddenly have a flow of requests. I don’t know if it will happen in the first quarter, or if clients 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 is little precedent to emulate. Data from the Loan Market Association released in October showed that, astonishingly, only 19 loans have been signed and made public in Libor jurisdictions that make reference to risk-free rates.
Looking on the bright side, Clare Dawson, chief executive of the LMA, says: “We’ve got an awful lot of the building blocks in place. One issue is that for borrowers it hasn’t exactly been a normal year [because of the pandemic] and they’ve had a lot of other challenges to cope with.”
Lenders, by contrast, have kept focused on the issue. “The banks, despite dealing with Covid, have still been pressing on with Libor work,” she says. “People haven’t been taking their attention off this.”
Every little helps
Although concrete examples of what works are few and far between, there are some handholds to grab on to.
So far, most of the blue chip borrowers that have tackled the issue have structured Libor-based loans that will convert to risk-free rates from 2022. British American Tobacco did this with a £6bn-equivalent dual tranche facility, signed in March.
GlaxoSmithKline went further in September by amending £3.8bn-equivalent of bilateral loans to run off risk-free rates immediately.
And in October, Tesco, the UK supermarket chain, signed a fresh £2.5bn-equivalent multicurrency three year loan that is based on risk-free rates from the off. “We just decided to go for it,” says Vowles. “We were expecting a few more [companies] to have taken the plunge, but this year has been challenging for a lot of people.”
Tesco’s loan is still based on Libor, but uses an adjustment spread to get to the risk-free rates. “We know our loan won’t be the end point [in setting the standard] because we’ve retained the credit spread adjustment,” says Vowles. “Ours is a stepping stone — you can’t wait for market standards to just land, someone needs to do something.”
Crucially, Tesco’s 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 scrapped.
“Most, if not all, of the banks are almost ready,” says Rabier at BNP Paribas, a bookrunner on the Tesco deal. “Many banks have put in place the systems to manage the rate.”
Not everyone is quite as confident that banks are good to go now, particularly when it comes to the systems needed. “[Lenders are] not going to want to deal with every facility off a spreadsheet; they are going to want their systems to administer everything,” says Dawson.
Whatever the assurances, it is hard to know exactly how ready anyone is until companies start using the new facilities. That is when spread calculations will be tested and the movement of money will show whether bank systems are up to the task.
“Proof will come with the first drawings,” says Rabier. “It will be a transition up to March or June next year. We will see a stabilisation of terms in that time and that will give some more confidence.”
It is possible that some corners of the market will not be able to get their processes together in time. Regulators have a plan for this — sort of.
The UK Financial Conduct Authority will be given new powers in the Financial Services Bill introduced to Parliament in October, to require the ICE Benchmark Administration, which administers Libor, to continue publishing it after 2021, in certain circumstances and under a new methodology — to help those struggling with old Libor-based contracts.
For banks, calculating loan interest rates might be difficult to achieve in time, particularly if the market does not settle on a unified approach to the fiddly mathematical equations needed to compensate for the slight difference between Libor and risk-free rates.
For all the effort of loan market working groups, how to do these is not settled. “There is still some work for people to do in relation to active transition before the end of 2021,” Dawson says. “That is, what do they do in terms of the credit adjustment spread from Libor to risk-free rates?”
The Federal Reserve, has also “been making noises about a safety net… allowing some product referencing Libor to run to maturity,” said Padhraic Garvey, head of research for the Americas at ING, in a research note.
Tough it out
Tough legacy contracts also affect derivatives, particularly when they are hedging a tough legacy loan.
ISDA has a solution for this. Its protocol creates a fallback rate for Libor contracts to default to when Libor is no more: the risk-free rate, plus the five year median difference between that and Libor.
Nonetheless, this remains a fringe concern, and like much of the Libor transition when it comes to loans, mostly hypothetical so far.
However, the more deals that are signed using risk-free rates, the easier and quicker the transition will become, like a snowball picking up pace as it rolls downhill.
“As more deals have been done and as we have put more documents out and people have studied and used them in transactions, we’ve been getting lots of comments,” says Dawson.
The loan market may find, however, that the snowball turns into an avalanche. GC