(Corrects the story of April 13 to change the SOFR to 1bp against 10bp in the fifth paragraph)
NEW YORK, April 22 (LPC) – A health emergency of unprecedented proportions has added another layer of complexity to the U.S. loan market’s transition from a key loan benchmark used to fix interest payments on billion dollars of investment as the deadline to switch to a new rate is fast approaching.
Companies such as General Electric, General Motors, and American Airlines all tie a portion of their interest payments to the London Interbank Offered Rate (Libor). Following the rate scandals resulting from the great financial crisis, a British regulator has said that by the end of 2021, markets should switch to a new credit benchmark.
A group backed by the Federal Reserve (Fed) recommended a move to the guaranteed overnight funding rate (SOFR), a broad measure of the cost of borrowing overnight cash secured by US Treasury securities. Libor is an average rate that banks say they would charge for lending to each other.
Companies typically tie their leveraged loans to a one-month or three-month contract, where they pay Libor to lenders plus a fixed interest rate.
Concerns over how best to manage the large spread differential between the two rates weighed on market participants. The 3-month Libor was set at 121bp on Thursday, while the SOFR was set at 1bp.
“The lack of an SOFR term is a big concern right now because people don’t know where they’re headed,” said Kevin Grumberg, partner at the law firm Goodwin Procter. “One of the main reasons people aren’t ready to commit is that it doesn’t look like a change from apple to apple.”
The switch to a new benchmark rate by the end of next year was already considered a success by many players in the loan market. Now, with the asset class focused on the impact of the coronavirus on borrowers and the economy in general, the transition is even further on the minds of investment professionals.
The UK’s Financial Conduct Authority, which requested the December 31, 2021 deadline, and the Bank of England are assessing the impact the coronavirus will have on meeting the transition date, Reuters reported last month.
“We only focus on the facts as we know them. Obviously anything can happen – these are very difficult times – but from the information we have today it remains clear that we should be following the tracks by the end of 2021 ”, said Tom Wipf, vice -President of Institutional Securities at Morgan Stanley. and the chair of the Alternative Reference Rates Committee (ARRC), which is working on the transition. “There is work we have going on during this time, and as you can see from our recent announcements, we have been able to move that work forward and will continue to do so. “
DEBATE ON TARIFFS
Concerns about the spread differential between Libor and SOFR have been at the heart of the transition debate.
While a difference is expected – as a risk-free rate SOFR has always been predicted to be lower than Libor – SOFR spikes have alarmed investors who are already wary of the change. In September, SOFR rose to 525bp, significantly higher than the three-month Libor of 216bp.
A spread adjustment has been proposed. The Fed-backed ARRC suggested adding fallback language to credit agreements, including a hard-wired approach that states that when Libor is no longer viable, the benchmark will move to a forward SOFR rate. forward plus a spread adjustment. If this was not possible, it will switch to compound SOFR plus a spread adjustment.
Last week, the ARRC recommended a spread adjustment methodology for cash products based on a historical median over a five-year retrospective period calculating the difference between Libor and SOFR, according to a press release.
“The critical moment is in the spread adjustment, which will be the only value added to SOFR in each existing contract to make it the same as Libor,” said David Wagner, senior advisor at Houlihan Lokey. “The ARRC addresses this in the new guidelines for cash products, but this is the area in which risk managers should watch for signs of value transfer on termination.”
ARRC’s announcement is good news for the transition. On the one hand, this will provide more certainty on the propagation methodology and, on the other hand, it will bring more visibility into the economy, said Meredith Coffey, executive vice president of the loan trade group, the Loan. Syndications and Trading Association.
The International Swaps and Derivatives Association will soon begin publishing an indicative spread adjustment. Using the five-year range should compensate for unexpected spikes or protracted bouts of volatility, Coffey said.
“This crisis will provide more data on the behavior of SOFR and Libor in times of crisis, so this information will be useful in structuring things in the future,” she said.
Nonetheless, operational transition adds to these challenges, so many institutions will need to address it before 2021, which could make it more difficult to meet the Libor transition deadline in around 20 months.
“There was still skepticism about whether to take the deadline (end of 2021) seriously,” Goodwin’s Grumberg said. “People now think more seriously that an extension should be considered.” (Reporting by Kristen Haunss and Michelle Sierra. Editing by Jon Methven)