Debt funds and LIBOR: so what the fuss
At the end of Episode 13 of Season 2 of HBO's Entourage (bear with me), the morally-bereft and anachronistic but somehow likeable agent Ari Gold sits in a car having just been fired from his employers. In the background Stevie Wonder's "For once in my life" comes on the radio. The episode is titled 'Exodus'.
At the risk of stretching the metaphor too far, perhaps there are some similarities with the comparatively slower demise of that lovable rogue LIBOR.
LIBOR in its current form is on the way out, that much is clear. But how will its exodus from the world of finance affect debt funds? Or, to borrow from another Stevie Wonder song, "So what the fuss"?
LIBOR as a basis
As we know in real estate finance, floating rate Sterling loans are typically tied to three month LIBOR. Other conventions in the funding documents will work around that basis, from payment obligations to the income-driven financial covenant tests.
Most of us should also now be aware that if, and when, LIBOR disappears from our screens, risk free rates (RFRs), like SONIA, are tipped to fill the gap.
RFRs as a basis
But are RFRs right for loans? Yes and no.
The industry is certainly converging on them as the most viable alternative, however they are not quite ready to be rolled out into loan agreements. They're not a drag-and-drop replacement yet. Why?
They are economically different measures, calculated on a different basis with different conventions. For more on this see Fieldfisher IBORs microsite: Loan markets.
To address this, various possible options for using RFRs for terms are emerging from industry working groups, but for now the focus is on two of these:
- Using a backward-looking overnight daily RFR compounded over the actual interest period (e.g. three months). The rate will only be known at the end of the interest period (although a 'lag' mechanism may be helpful to 'fix' the rate for a short period ahead of the interest payment date).
- Using a forward-looking term rate, which will be known at the start of the interest period and built on the basis of the futures or OIS market of that RFR.
Both these options still differ fundamentally from LIBOR for any particular tenor and will need to add a credit/term risk spread.
This sounds complicated, so will LIBOR live on?
Returning to Entourage, briefly and with a spoiler alert, Ari Gold doesn't take long to resurface, and in a scarcely reformed guise. As to whether LIBOR will persist, the answer is "possibly" and certainly if its current administrators have anything to say about it. But regulators and trade associations are keen to stress that it is not sensible to rely on a reanimated/reformed LIBOR being suitable.
What are borrowers saying?
Some of the larger and more experienced players in Sterling markets have begun to express a preference for transitioning to backward-looking compounded rates however this is not a universal position. Much will depend on a borrower's ability to adapt their operations and systems to work on that basis, and their familiarity and use of other markets where such rates are used. (The same of course applies to lenders.)
Documents
Obviously LIBOR discontinuance or the market transition to RFRs will affect both existing deals and new transactions being papered now and beyond 2021.
Much has been made of "fallbacks" and the extent to which finance documents can flex to respond to new rates and conventions. But rate fallbacks are only part of the solution – and in some instances may compound the issue (pardon the pun). Deals papered in the not-too distant past may not include particularly sophisticated long-term fallback mechanisms (or, pre 2014, any at all) and they may leave lenders relying on an unsustainable reference bank or cost of funds basis. Without the ability to negotiate a more appropriate solution, including adjustments for new conventions and margin resets, loans may have to be repaid or refinanced ahead of time.
The LMA's screen rate riders (last published in December 2018) build in some further flex but they don't go as far as recalibrating the loan agreement to work with RFRs, they simply provide a framework (itself malleable) for the parties to come together to amend their agreement.
Of course what looks like a simple mechanism on paper, to negotiate a new basis, somewhat belies the inevitable skirmishes around what is an appropriate or workable rate for all parties and the calculation of any credit/term risk spread. Pricing will always be a sensitive issue.
In that context, consider also any risk-based term sheet disclosures. That is, the need for a statement to the effect that any LIBOR basis is subject to the discontinuation of that rate and its replacement with an economically different alternative rate.
Is there anything else to think about?
Security documents, guarantees and other third party credit support are not immune from vulnerability here. For both new and existing deals it's worth considering to what extent would any changes in the benchmark rate, including the calculation and payment conventions, fall within the scope of those arrangements.
Where funds are investing on a loan-on-loan basis, it will be crucial to avoid a mismatch. That is, ensuring the basis of rate you lend out at (and the commensurate debt service regime for that loan) is aligned with the basis of the rate you are borrowing on.
Are your systems or those of your loan operations provider set up to work on an RFR basis? If not, will you, or they, be able to build new systems in time for 2021 (or sooner!) that reflect a possible industry shift to backward-looking compounded rates? (Given progress, forward-looking term rates are perhaps a more distant possibility at this stage.)
And don't forget any floating rate hedging. Efforts are being made to coordinate with other markets but there is a danger that derivatives may go down a different route to the cash markets, creating further potential for basis risk.
A final word
By Episode 8, Season 8 ('The End'), Ari's career ultimately succumbs to a world moving on without him; where new ways of doing things superseded the conventions of the past. It is highly likely that current LIBOR-based funding is similarly afflicted. The key is how well you are positioned to do business in a post-LIBOR world.
1This blog focuses on discontinuance in the context of Sterling LIBOR, however it is acknowledged that other interbank offered rates are undergoing review and reform and that, for example, alternative RFRs are being developed for the Euro (ESTER), US Dollar (SOFR), Swiss Franc (SARON) and Japanese Yen (TONAR).