LIBOR: Moody Blues

June 20, 2018 - As LSTA members undoubtedly know, LIBOR potentially will cease after the end of 2021. So how do the rating agencies think about potential LIBOR cessation and its impact on credit? As Moody’s reported in May, “Uncertainty over future of LIBOR is broadly credit negative”. That said, the rating agency is not necessarily opposed to a post-LIBOR world; instead, Moody’s explains that full impact of a potential LIBOR cessation is unclear – and uncertainty in itself is a credit negative. This uncertainty arises for a number of reasons. First, documentation and LIBOR fallbacks may be inadequate. (Of course, because syndicated loans are shorter-tenored and more easily amended, they may be in the best fallback position of nearly any cash asset class.)  Second, upon transition to a new rate, the holders of LIBOR-linked loans, bonds or hedges may receive lower (or higher) rates than they anticipated.  (Conversely, borrowers may pay a lower or higher rate.) Third, asset-liability mismatches may be created or altered. Fourth, because some are secured and some are unsecured, the new benchmarks for different currencies will not be as similar as the IBORs and they likely will be more volatile than the IBORs. Fifth, the selection of a new replacement rate (and any credit spread adjustment) likely will reflect the bargaining power of the parties – and thus may lead to winners and losers. Finally, increased litigation risks and operational costs may weigh on some borrowers’ credit profiles.

But fortunately the transition itself should not lead to defaults. First, Moody’s notes that many LIBOR-based instruments will mature or be refinanced prior to 2021. (To be clear, Moody’s is discussing all instruments, not just loans.) Second, even with the instruments that remain outstanding after LIBOR cessation, it is unlikely that Moody’s would declare a default if outstanding transaction were restructured if such a restructuring is in line with a clear market convention. 

Moody’s goes further and discusses other potential outcomes in case the documents are silent on LIBOR cessation: 1) No change at all (e.g., LIBOR converts to a fixed rate). 2) A voluntary negotiated outcome between LIBOR payers and receivers. 3) A mandated outcome by regulators or legislators. 4) Disputed outcomes that must be resolved by the courts. None of these would result in a Moody’s default, except if a “voluntary” negotiated outcome were concessionary to avoid a cash flow default. This would constitute a distressed exchange.

Still, while agreement changes are unlikely to trigger defaults, Moody’s points out that defaults might occur if LIBOR cessation reduces the effectiveness of hedges to the extent that cash flows become insufficient to service debt.  All of this highlights the importance of developing more certainty quickly.

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