Meredith Coffey of LSTA provides readers with an update on the LIBOR transition.

1. When is LIBOR ending?

   The UK’s Financial Conduct Authority (“FCA”) – the regulator of the ICE Benchmark Administration, the administrator of LIBOR – has said that all sterling, Swiss franc, euro and Japanese yen LIBOR settings will cease or no longer be representative after year-end 2021. The FCA also said that the settings for one-week and two-month USD LIBOR will also cease or will be non-representative after year-end 2021. The remaining USD LIBOR tenors will cease or be non-representative after June 30, 2023. Importantly, while USD LIBOR will continue to exist after the end of 2021, this is only for pre-existing “legacy” contracts. The U.S. banking regulators have said that banks should not originate new LIBOR contracts after the end of 2021.

2. What have the U.S. banking regulators said about LIBOR cessation?
   

   In an announcement of a “Supervisory and Regulatory” letter[1]from November 30, 2020, the U.S. banking regulators stated that they “believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly. Therefore, the agencies encourage banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021, in order to facilitate an orderly—and safe and sound—LIBOR transition.” In addition, the U.S. banking supervisors have delivered informal messages reiterating the importance of starting non-LIBOR originations ASAP. They have generally indicated that they prefer SOFR for most contracts, but acknowledged that credit-sensitive rates (CSRs) may have a role to play in traditional lending products. They have indicated that they are interested in an orderly transition and minimizing systemic risk. They do recognize that there are instances where banks have a pre-existing contractual obligation to fund in LIBOR after December 31, 2021 – such as draws on pre-existing revolvers – but they also want to see LIBOR exposures decline significantly after year end.

3. What are the possible replacement rates?

   For most products in most jurisdictions, the major replacement rates typically are Risk Free Rates (“RFRs”). The U.S. RFR is the Secured Overnight Financing Rate (“SOFR”), which is based on overnight Treasury Repo Rates. SOFR is large (nearly $1 trillion of underlying Treasury repo transactions occur daily) and hard to manipulate. Because it is an overnight rate, the market has developed mechanisms to create a rate with tenor by calculating an average SOFR rate (in advance or in arrears). The CME also is publishing forward-looking Term SOFR; loans were included in ARRC’s scope of use of Term SOFR in Summer 2021. Other jurisdictions are using “Daily Compounded RFRs” and thus the LSTA and the ARRC also have worked to operationalize a “Daily Compounded SOFR”, though this is not expected to be used broadly in the U.S.

   In addition to risk-free RFRs, the U.S. has been developing Credit Sensitive Rates (“CSRs”), which include a credit risk component and generally behave more like LIBOR than do the RFRs. CSRs include Bloomberg’s BSBY, AFX’s Ameribor, IBA’s Bank Yield Index, Markit’s CRITR and SOFR Academy’s AXI. In general, these are term rates (CRITR and AXI also are published as spreads to SOFR) that are built from bank funding markets, including rates on bank deposits, CP, CD and traded bank bonds.

4. What are the economic implications of SOFRs vs Credit Sensitive Rate (CSRs)?

   There are two major differences economically between SOFR and the CSRs generally. First, SOFR is a risk-free rate and the CSRs are credit sensitive rates, so CSRs should generally be higher than SOFR. As an example, the five-year historical median difference between 3M LIBOR and 3M SOFR is +26 bps.

   While CSRs are typically higher than SOFR, the rates also should behave differently in a financial disruption. When markets are disrupted, SOFR – a secured, risk-free rate related to monetary policy – will tend to drop. In contrast, a CSR – which includes a component for bank credit risk – may well widen. While rare, this behavior was seen in the 2008 financial crisis, as well as in the March 2020 Covid-19 crisis. Because CSRs provide some protection for lenders in a market disruption, particularly for undrawn loans with an option to draw at any time, some banks would prefer to use them for bank-held loans.

   Importantly, both CSRs and Term SOFR are known in advance of the interest period and are documented and operationalized nearly exactly the same way as LIBOR. For this reason, parties who are not interested in credit sensitivity and instead are concerned solely with the systems/operations changes of shifting from LIBOR should be able to easily work within a Term SOFR world.

5. What is a “multi-rate” environment?

   Today, U.S. leveraged loans almost universally use LIBOR as a reference rate. This means that all loans are operationalized and documented similarly and, from a return perspective, parties focus primarily on a loan’s spread, not its reference rate.[2] In the coming months and years, leveraged loans are likely to reference a number of rates – many of which will have different economics and operational constraints.

   Recall that no new LIBOR loans can be originated after year-end 2021, but legacy LIBOR loans have until June 30, 2023 to switch to a replacement rate. This means that, at a minimum, there will be loans outstanding both on LIBOR and a replacement rate. (And at least initially, there’s a good chance that multiple replacement rates will coexist.) Because the economics – and sometimes the operations – of LIBOR and its replacements differ, lenders, investors and traders must be cognizant of both the spread and the reference rate of every loan.

6. How might loans transition from LIBOR to a replacement rate?

   There are several ways that a loan might transition from LIBOR to a replacement rate. The surest method is simply to refinance the loan directly into a replacement rate (like SOFR or a CSR) prior to June 30, 2023. This approach removes all uncertainty and places all control in the hands of the counterparties.

   However, some companies may wait until USD LIBOR ends on June 30, 2023 and “fall back” through the provisions set forth in their loan documents. There are two types of LIBOR fallback language: amendment approach and hardwired approach. If a company has an amendment fallback, it and its agent typically will agree to a new reference rate (and spread adjustment, where appropriate, to compensate for the economic difference between LIBOR and the replacement rate); “Required Lenders” typically have a five-day negative consent period. If they do not object, the replacement rate amendment passes and LIBOR is replaced. If “Required Lenders” do object, the loan switches to Prime and the amendment process begins anew. While the amendment approach offers flexibility, it lacks certainty and is more onerous to execute than hardwired fallback language.

   Alternatively, a company might have ARRC (or substantially similar) hardwired fallback language. In that event, after LIBOR ceases or is determined to no longer be representative, the loan would fall back to a replacement rate determined using a “waterfall” of potential replacement rates, along with the ARRC fallback spread adjustment. If Term SOFR exists and is formally recommended by the ARRC – which will almost certainly be the case – then the loan would fall back from LIBOR to Term SOFR+ARRC spread adjustment. If Term SOFR does not exist or is not recommended by the ARRC, then the loan would fall back to Daily Simple SOFR+ARRC spread adjustment. If that too does not exist (which would be highly unlikely), then the replacement rate and adjustment would be determined via the amendment process described above. The ARRC spread adjustments are the five-year historical median difference between each USD LIBOR tenor and the corresponding compounded average of SOFR; they were set on March 5, 2021 with the one-month adjustment set at 11 bps and the three-month adjustment set at 26 bps.[3]

   Finally, many sets of fallback language – amendment and hardwired – include an early “opt-in” feature. Generally, the early opt-in becomes available when syndicated loans are being amended or executed to reference an alternate benchmark. This feature allows for interested parties to transition away from LIBOR avoiding any potential disruption of the simultaneous transition of multitudes of loans. 

7. Can replacement rates be hedged?

   Replacement rate loans are hedgeable, albeit with varying degrees of liquidity and “perfection”. The most liquid hedging scenario is one where the loan uses Daily Compounded SOFR. This rate likely will be the most liquid for hedging and may allow the borrower to approach a perfect hedge. However, the Daily SOFR rates are not known in advance of the interest period, something borrowers strongly desire. End users also may hedge CME Term SOFR, though those hedges are likely to be less liquid than Daily SOFR hedges. Likewise, CSRs should be hedgeable, though their hedges might not be as liquid as SOFR hedges.

8. What should I be doing now?

In many ways, we are in the last days of the LIBOR transition. Banking supervisors have made clear that LIBOR originations must stop by the end of the year. Given this looming deadline, focus should be squarely on non-LIBOR originations and the remediation of any credit agreements impacted by the cessation of the other LIBOR currencies, i.e., multicurrency facilities. Moreover, market participants need to be prepared for living in a multi-rate environment – whether that be just LIBOR and SOFR or LIBOR, SOFR and CSRs.  Once originations are up and running by the end of the year, market focus should swiftly shift to the remediation of legacy loans and CLOs. We have been given the gift of time on legacy transactions – but only 18 months! – and market participants should take care not to squander it.