January 7, 2020 - As of January 7, 2020, there are 724 days until the potential end of LIBOR. Will the syndicated loan market be ready?
As the timeline below demonstrates, much work was done on LIBOR transition in 2019. And the pace will only accelerate in the coming year as LIBOR nears. In the loan space, two critical efforts need to be nailed down. First, we would be well advised to shift from “amendment” fallbacks to “hardwired” fallbacks. Second, the market needs to start originating SOFR loans (or, at least, loans that embed an option to switch to SOFR).
Key LIBOR Transition Dates
- April 2018 – SOFR launched
- 4Q18 – ISDA identifies SOFR Compounded in Arrears for Fallbacks
- April 2019 – Indicative SOFR Compound Averages and Term Rates published
- 2Q19 – ARRC Loan, FRN and Securitization Fallbacks published
- June 2019 – ARRC Business Loans Operations Workgroup launched
- 2-3Q2019 – Accounting and tax clarity emerge
- 4Q2019 – $10B SOFR linked loan syndicated
- 4Q19-1Q20 – Operationalization clarity from loan vendors
- 1Q20 – ISDA launches LIBOR Fallback Indicative Spread Adjustments
- 1Q20 – LSTA releases SOFR “Concept Credit Agreement”
- 1H20 – ARRC launches SOFR Index and official Compound Averages
- 2H20 – Hardwired fallbacks emerge in loans/accelerate in CLOs
- 3Q20 – SONIA cash products to stop LIBOR issuances
Fallbacks: There are two approaches to fallbacks for loans. The “hardwired” approach generally states that when LIBOR ceases, the contract falls back to SOFR plus a spread adjustment. However, most loans are relying on the “amendment” approach, which generally i) has the agent and borrower identify a replacement rate and possible spread adjustment and ii) permits required lenders a five-day negative consent period to object to the proposal. If required lenders reject the proposed rate, the loan will fall back to a Prime-based rate while the agent and borrower submit a new proposed rate. While the amendment approach maximizes flexibility for the borrower to pick a replacement rate (and for lenders to reject it), it has a number of shortcomings, including executability, economic uncertainty and potential for market disruption.
First, executability: There are over 10,000 U.S. dollar LIBOR loans outstanding according to Bloomberg. While a number of loans may be amended in short order after LIBOR ceases, thousands more may not get their amendments done quickly, forcing borrowers into a Prime-based rate for a period of time.
Second, economic uncertainty: Because we know SOFR rates (and will know spread adjustments soon), the economics of a hardwired fallback will be known and markets can adjust. In contrast, the outcome of every fallback amendment is unknown and therefore lenders and borrowers will not be able to forecast their interest rates. Importantly, there could be gamesmanship. Powerful companies may force lenders to accept uneconomic terms, while underperforming companies will be at the mercy of their lender group and may have to pay up to have their fallback amendment approved.
Third, potential market disruption: Because loans with hardwired fallbacks will have modelable cash flows, the secondary market will be able to value these loans efficiently. The cash flows of loans with amendment fallbacks will less certain, potentially leading to discounts in the secondary.
Clearly there are market-wide benefits for switching to hardwired fallbacks. But how do we get there? Three preconditions may be necessary: i) the economics of hardwired fallbacks should become clearer, ii) SOFR should be operationalizable, and iii) the potential benefits of certainty outweigh the benefits of flexibility. We think these will emerge in 2020.
First, economics: We now have 20 months of SOFR rates to observe, the FRBNY has been publishing indicative compound SOFR and forward looking term SOFR for nearly a year and, as the timeline demonstrates, the FRBNY plans to publish official compound SOFR rates in early 2020. In addition, ISDA will publish their indicative spread adjustments for LIBOR fallbacks in 1Q20. This means that, for derivatives at least, we will soon know both SOFR and the spread adjustment for contracts that fallback from LIBOR. The economics will be clear.
Second, operationalization: The LSTA and ARRC BLWG Operations Subgroup have been running whiteboarding sessions for months to determine exactly how SOFR loans can be operationalized. At least one vendor has announced it has an operational solution and others should follow quickly. Moreover, the U.K. has announced there should be no more Sterling LIBOR issuances – including loans! – after 3Q20. Loans use the same systems for Sterling and Dollar LIBOR, and SONIA (the Sterling replacement rate) and SOFR would operationalize similarly. Thus, the earlier deadline for SONIA will accelerate the operational feasibility date for SOFR.
Third, certainty vs. flexibility: While borrowers have preferred the flexibility of the amendment approach, we believe that the market has increasingly accepted that SOFR is the fallback rate for syndicated loans. As borrowers become familiar with SOFR – and internalize the downside risks in the amendment approach – we believe that the hardwired approach will become more palatable.
New Loans: Of course, even a hardwired fallback is an imperfect solution. It would be far preferable to have new loans originated on SOFR or with a SOFR option so that no fallback is necessary. For banks to start originating SOFR loans en masse, there are several preconditions. First, there must be loan systems that can operationalize SOFR. Second, there must be SOFR loan documentation. And, third, there must be borrower (and lender) appetite for SOFR loans. Happily, all three prerequisites are emerging. As mentioned above, banks and vendors are assiduously working to operationalize SONIA and SOFR. The fact that Sterling LIBOR loans should not be originated after third quarter 2020 means that we will have systems that can handle SOFR this year. To address documentation needs, the LSTA is developing SOFR Concept Credit Agreements, which can be used as a basis for market discussions or templates for new documentation. Finally, Shell Corporation already indicated an appetite for a ($10 billion!) SOFR-linked loan. We believe that as more companies understand the economics of SOFR and internalize the risk of overstaying on LIBOR, they will begin to ask for SOFR options in their loans.
The LSTA is a member of the ARRC itself, co-chairs the ARRC Business Loans Working Group and its Operations Subgroup. To educate our members, the LSTA hosts weekly LIBOR Live Q&A calls. For more information on LIBOR, please write to us at firstname.lastname@example.org.