LIBOR is the average interbank interest rate at which a selection of banks with access to the wholesale, unsecured funding market could lend to other banks in such market in particular currencies for certain tenors.
Since the 1980s LIBOR has been the predominant interest rate for financial products. As a result of increased market and regulatory scrutiny since the 2007/2008 global financial crisis various changes have taken place including a reduction in the number of transactions which underpin the estimates submitted by panel banks to Intercontinental Exchange (the independent administrator of LIBOR). As LIBOR is dependent on sufficient liquidity in the bank market, a reduced number of transactions has led to the view that it no longer represents a true reflection of the interbank rate. LIBOR is therefore being replaced at the end of 2021 whilst in the interim period the FCA has been able to secure voluntary agreement from the banks that submit to LIBOR to fulfil their role in submissions so that LIBOR can continue until the end of that period.
So how are companies and lenders preparing for this change?
We reported in our Q1 2021 Snapshot that very few loan agreements were being amended to cater for IBOR cessation, and that most companies and lenders were deferring addressing the issue as long as possible. Q2 2021 has seen a stark change, showcased by numerous requests—both new requests and requests as part of a wider transaction where other amendments are being made. For example, the mid-market, which is punctuated with buy-and-build strategies, has been extremely busy, with M&A volume up significantly compared to the same period in 2020. Utilising a red-hot credit market has meant documentary amendments, and we have seen IBOR amendments almost always being incorporated simultaneously.
Whilst it appears that most loan market participants are choosing some formulation of the sterling overnight indexed average (SONIA) as an alternative to sterling IBOR, approaches to actually documenting that change may vary. Some lenders prefer to start with sterling IBOR in the ordinary course and include a mechanism for the benchmark rate to immediately switch to SONIA upon the occurrence of certain trigger events, typically the earlier of (a) sterling IBOR no longer being made available as a screen rate or (b) a backstop date. Other lenders are dealing with the issue more immediately and including SONIA as a day one benchmark rate. In both cases, loan documentation must be re-engineered to include the mechanics for SONIA, a process that has proven even more complex for multi-currency loan agreements through which non-sterling currencies will continue to accrue interest on the basis of IBOR. Given the varying approaches in different jurisdictions, the task is not a small one, and some stressed and distressed groups with more complex currency needs have resorted to ceding the right to draw in sterling to preserve cash flow.
Almost all loan agreements use the Loan Market Association suggested approach (with some limited deviation): they use SONIA alongside a five-business-day lookback period. What is less settled is whether the credit adjustment spread (CAS) ought to be included. There is a small economic difference between sterling IBOR and SONIA which results from, amongst other things, the term credit risk premium that is built into sterling IBOR but not SONIA. The market has used CAS to mitigate this economic difference, but some sponsors may see this as an unnecessary attempt to preserve additional economics. The market will hopefully settle on whether sterling IBOR’s transition should give rise to an economic premium for borrowers versus the agreed replacement rate, or whether lenders previously receiving sterling IBOR should maintain their existing economic standing, irrespective of the change to reference rates.
Where CAS has been used, it is typically calculated using a five-year historical median—based on the difference between sterling IBOR for a particular interest period and SONIA compounded in arrears over the same period calculated using a median over a five-year lookback period (i.e., looking at historical differences between sterling IBOR and SONIA compounded in arrears over a five-year period). Bloomberg publishes CAS calculated using the above methodology for different tenors of sterling IBOR. Different approaches have been taken, and either the upfront percentage from Bloomberg is applied for the duration of the loan, or it is the Bloomberg CAS rate at the relevant time. Perhaps there will be more clarity on approach to this point in our next Snapshot.
Finally, whilst there has been an increased impetus on European transactions where sterling IBOR is referenced, other jurisdictions (including the United States) continue to defer the issue until closer to the deadline, particularly given the recent suggestion that there might be more than one approach.