The Financial Conduct Authority’s decision to call an effective end to LIBOR by 2021 means a new benchmark is needed for floating-rate products, but despite some consternation after the FCA announcement, the global leveraged loan market appears in little hurry to find a replacement.
To be sure, given the typical seven-year tenor of floating rate leveraged debt, a good chunk of loans and bonds underwritten today could be outstanding beyond the benchmark’s end-date. In the first instance, this is not a problem, as loan documents contain fallback clauses that provide alternatives should LIBOR not be available.
These include an expansion of the definition of LIBOR to a deposit rate for London market banks, or an interpolated rate from designated reference banks. The New York–based Loan Syndications & Trading Association points out that lenders and borrowers could enforce a “market disruption clause” to switch the benchmark to a base rate or prime rate, even if this would be at an almost certainly higher rate.
In London, the Loan Market Association has recommended since 2014 that loan documentation include provisions, and while these were not designed as a full replacement, lawyers say they should be more than adequate.
Longer term, sources agree that fallback clauses do not provide a solution.
“The market needs to start a deliberate process to think about what the alternatives to LIBOR are going to be” said Judah Frogel, a partner at Allen & Overy New York, who pointed to work that has already begun at the LSTA as among the first steps down this route.
That said, the absence of clear alternatives means changes to documentation are likely to be gradual rather than revolutionary, and will need to be flexible enough to meet changing market standards.
“There is not an obvious proxy for LIBOR at the moment. Borrowers and lenders will need flexibility in their document language to allow for changes in line with whatever the market chooses as the new standard reference rate,” adds Frogel, who expects that docs are likely to start to incorporate some of these changes within the next 12–18 months.
At present, any change in benchmark rates beyond provisions in docs typically requires total lender consent, which can be difficult to achieve. Therefore, doc amendments will give borrowers the flexibility to adopt new standards without actually stating what these standards may be.
There are several alternative rates that could potentially replace LIBOR, though none appear totally satisfactory.
In the U.S., the Alternative Reference Rates Committee has said a broad Treasuries repo financing rate is an appropriate reference rate for dollar derivatives and other contracts. This benchmark, however, is not as liquid and widely traded as LIBOR, and the BTFR also has traded 30 bps lower than the interbank rate over the past three years, according to Bank of America Merrill Lynch.
On the other side of the Atlantic, a working group on sterling risk-free reference rates has recommended SONIA as an alternative for sterling LIBOR in the derivative markets. This is a rate based on wholesale unsecured overnight loans, and participants have asked whether this rate is too backward-looking for loans.
This is because a lending benchmark, they say, needs to capture an element of credit risk—and even the increasing burden of regulatory risk. These thoughts are echoed in the U.S., where sources point out that the BTFR is the repo rate of securities backed by U.S. government collateral rather than a short-term unsecured lending rate. Mining down into leveraged lending further, others even wonder whether a rate that seeks to reflect bank cost-of-funds is still relevant for a market that is now largely institutional in nature—on both sides of the Atlantic.
These debates, in part, highlight the fact that lending markets are just one user of LIBOR and similar rates.
“The loan market is a consumer of LIBOR. We have to work with other parties to ensure an appropriate benchmark is adopted,” said Nick Voisey, a managing director at the LMA, who added that the group continues to study the implications of the FCA’s announcement.
Other financial markets, such as the futures, interest rate derivatives, asset backed securities, and commercial real estate loans, must also deal with any potential challenges to LIBOR, including the possibility that a quotable market may not exist by the FCA target date.
The difficulty in finding a suitable replacement has led some to call for regulators to step in. In particular there are fears, including from such industry giants as PIMCO, that the market could bifurcate rather than smoothly transition to a new rate without a clear regulatory mandate.
Wells Fargo’s rate strategists laid out these worries earlier this month. “Regulators can press banks to participate. However, buy-side customers’ willingness to be involved will heavily influence whether the new reference rate is a success … Dealers, hedgers, and investors will need to manage the basis between LIBOR and the new rate structure,” the bank said in a note.
PIMCO adds that a regulatory mandate may be necessary, but only until the alternative benchmark has enough liquidity, a full term structure exists for investors, and investors are provided enough time to properly assess any impacts to their valuations due to any differences between the rates.
But despite the seemingly complex nature of the task, arrangers and investors are for the most part sanguine.
“If LIBOR goes away tomorrow, the loan market could and would operationally move on,” Eaton Vance said in an Aug. 16 publication that suggested there is little reason to panic—just yet. As the fund manager points out, a third of the $1 trillion loan market repays each year. Or phrased differently, the entire market turns over in three years, giving time for new loans to adopt any changes. — David Cox/Andrew Park
This story first appeared on www.lcdcomps.com, an offering of S&P Global Market Intelligence. LCD’s subscription site offers complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.