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Capital Markets

Libor-Replacement Fallbacks Out for Comment

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November 05, 2018

Proposals for corporate-favored term SOFR expected soon

Blue fish red fishThe Alternative Reference Rates Committee (ARRC) is requesting comments by November 8 on so-called fallbacks for syndicated loans and floating-rate notes, in the event the London Interbank Offered Rate fades or disappears altogether. The proposals were issued in late September, and since then the ARRC has announced plans to propose term rates for its Libor replacement, which upon reaching fruition will provide a third fallback option.

The Secured Overnight Financing Rate (SOFR) chosen by the ARRC to replace Libor settlements overnight so that borrowers of a one-year loan based on SOFR, for example, wouldn’t know their payment until the end of that period, after compounding each day’s rate. That’s a problem for most corporates seeking to manage cash efficiently, since they prefer to know in detail what payments are coming down the pike.

Switching from, say, 3-month Libor to a 3-month term SOFR would provide a similar forward-looking rate and clearly facilitate a transition away from Libor, which is based off an ever-shrinking and increasingly unreliable volume of interbank loans. Of course, much depends on the proposal for term SOFR rates offered by ARRC, given the group of industry representatives noted in a March 2018 report that the term-SOFR alternatives it was considering then were “unsuitable.”

The head of interest rates structuring and solutions at BNP Paribas told members in an October NeuGroup meeting that regulators were concerned “term fixing” for SOFR would introduce many of the problems faced by Libor today, such as a lack of liquidity.

“They want to use a rate based on the highest possible transaction volume,” the banker said, adding that was the primary reason they chose SOFR, which is based on upwards of $800 billion in repurchase agreement-related transactions daily.

The ARRC opted to give developing term-SOFR rates another try, the banker said, because the feedback ARRC members received from end users made it clear they viewed term-SOFR rates as highly desirable.

In its proposals for syndicated-loan and floating-rate-loan proposals, the ARRC notes that most contracts for cash products today “do not appear to have envisioned the permanent or indefinite cessation of Libor and have fallbacks that would not be economically appropriate if this event occurred.” The proposals, hence, aim to create “robust fallback provisions” that define fallback triggers and allow for the selection of a “successor rate,” as well as a pricing spread adjustment between Libor and that successor rate to account for differences between the two benchmarks. The proposals also intend to address timing and operational mechanics “so that the fallbacks function effectively.”

The proposals state that products across the derivatives, loan, bond and securitization markets should operate in a consistent fashion in the event Libor ceases, thereby reducing operational, legal and basis risk, although upon further analysis some differences may be appropriate.

The syndicated-loan proposal offers two fallback options, including the “hardwired approach” that aligns most closely with the goal of providing consistency. In that approach, lenders and borrowers will receive a version of SOFR plus a replacement-benchmark spread when Libor is discontinued.

“However, term SOFR and the replacement benchmark spread do not yet exist, so it may be hard to determine today what the ultimate replacement rate would look like,” the proposal says. The International Swap and Derivatives Association’s (ISDA) fallback proposal for derivatives, for which comments were due by October 22, is straightforward and probably easier to implement because transactions are based on standard contractual language. It sets out four options to move from a term rate to an overnight rate—there is no term option in the proposal—if Libor is permanently discontinued. ISDA plans to amend its 2006 ISDA Definitions to incorporate the chosen fallback language in future transactions, and it expects to publish protocol that would include the language in legacy transactions for counterparties agreeing to the protocol.

The Loan Syndications and Trading Association (LSTA) said in a Sept. 13 note that, on the plus side, the cash products’ proposed hardwire approach should enable the transition of thousands of loans simultaneously.

“Additionally, because terms are agreed upfront, there should be limited ability for participants to game the outcome. However, the hardwired approach relies on components which do not currently exist,” the LSTA says, adding that should those components remain unavailable, the hardwired approach could fall back to the amendment approach.

The “amendment approach” would instead provide a streamlined amendment mechanism for negotiating a replacement benchmark in the future. The proposal says that the amendment approach uses syndicated loans’ flexibility to create a simpler, streamlined process that is similar to the Libor-replacement language that has developed in the syndicated loan market over the past year.

In the NeuGroup meeting, one member noted that discussions with lenders about a new revolving credit facility have included “putting in language that leaves it open to slip in appropriate [fallback] language in the future.” He later noted that the large banks are encouraging such language in new loans’ contractual language.

The ARRC’s proposal adds that the amendment approach maximizes flexibility and avoids the risk of relying on a term SOFR rate and spread adjustment methodology that has yet to be developed.

“However, it may simply not be feasible to use the amendment approach if thousands of loans must be amended simultaneously due to an unexpected Libor cession,” the proposal says. “This could create the very real possibility of a disruption in the loan market.”

It adds that the amendment approach is also likely to create “winners and losers” in different market cycles, so that in a borrower-friendly market the borrower may be able to extract value from lenders by refusing to include a compensatory spread adjustment when transitioning to SOFR. In a lender-friendly market, instead, lenders might block a new proposed rate, requiring borrowers to pay a higher interest rate for a period of time.

Fitch Ratings said in an October 9 note that “the requirement to renegotiate such margins on an ad hoc basis may provide lenders an advantage in a rising interest-rate environment.” The note points out that the ARRC amendment approach does not require lenders to object to spread replacements in good faith. A second-lien credit agreement inked recently by The Goodyear Tire Co., instead, contains language that could “prevent lenders from taking advantage of a higher interest rate environment by limiting objections to those that ensure a market rate return.”

For these reasons, according to ARRC, its working-group members who currently support using the amendment approach generally believe that “eventually some version of a hardwired approach will be more appropriate,” and the amendment approach could serve as an “initial step.”

The ARRC’s proposal for floating-rate notes, issued less frequently by corporates, outlines a six-step waterfall approach to determine a successor benchmark rate, plus a spread, should Libor cease or appear likely to cease. The first step would transition borrowers to a term-SOFR replacement, and if such a term rate cannot be developed the second step in the waterfall would compound overnight SOFR rates during the interest period to generate the payment rate. The third step, if necessary, would set an overnight SOFR rate prior to an interest period, say a three-month period, and similarly reset it for the next three-month period, and so on.

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