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What is the LIBOR transition and what is it transitioning to?
LIBOR is being phased out due to concerns that the underlying market it is derived from is no longer sufficiently liquid; the LIBOR submissions made by banks are no longer based predominantly on actual transactions. As a result of this, LIBOR is being replaced by alternative risk-free rates (RFRs). SONIA is the recommended RFR for Sterling LIBOR which is administered by the Bank of England.
What are RFRs?
RFRs are overnight rates based on wholesale transactions. They are based on actual transactions that reflect the average of the interest rates that banks pay to borrow overnight from other financial institutions and other institutional investors. The underlying markets for RFRs are active and liquid and are therefore highly representative of the actual market.
What is the key difference between LIBOR and SONIA?
LIBOR is a forward looking rate. This means that borrowers know the cost of their borrowing at the start of each interest period. However SONIA is backward looking. Therefore borrowers using SONIA will only know the floating rate at the end of each interest period; borrowers will not have certainty upfront about the interest payments for that period.
What are the options available for the transition?
If you have LIBOR loan(s), your bank should have already contacted you with the options available to you. You would either actively transition away from LIBOR prior to its cessation and switch to SONIA (or another RFR), or you can take no action and the agreed fallback provisions will apply.
What effect will the transition have on my loan(s)?
Since SONIA does not include a credit/liquidity risk premium, it typically fixes below LIBOR. This means that the bank will most likely add a spread (“spread adjustment”) to your new RFR in order to keep the all-in interest rate the same.
Depending on when the transition happens, the spread adjustment methodology will differ as per below:
Existing roll dates and maturity dates should be maintained where possible.
What are the key risks?
Fallback provisions:
Above all, remember that the Regulators have stipulated that there should only be a ‘minimum’ cost to the borrower of this change – but what does this mean in practice and how can you check this?
You would need to check whether there are fallback provisions contained within the loan agreement and assess their robustness.
Even though existing loan agreements may include fallback provisions in the event that LIBOR becomes unavailable, such provisions were not intended for LIBOR’s permanent cessation. Therefore it is unlikely that the loan facility agreements prior to 2020 would include permanent replacement rates.
If the necessary amendments are not made in the loan agreements, the existing fallbacks may have to be relied upon. These existing fallbacks (unless robust and actually cover the permanent cessation of LIBOR) should not be used as a primary transition method.
Hedging:
If you have hedging in place, you will need to consider whether the fallbacks within the hedging documentation behave differently to those within the loan facility agreements that are being hedged.
After assessing and considering all associated risks, ultimately a decision will need to be made whether the related hedging will undergo the transition at the same time as the loan or not. The terms of the fallback rate and spread adjustments may not be consistent, hence this mismatch could adversely affect the borrower.
Mismatches can also occur due to SONIA loans applying a daily floor if that were not the case in the derivatives market. Therefore the compounded rate may be different for the loan and derivative (if there are negative SONIA fixings in an interest period).
Accounting:
There can be various considerations which have implications for accounting, mainly depending on the modifications of the loan, whether there is hedge accounting being applied to a hedge and how to change derivative valuation methodologies. Please contact us to discuss this complex topic in more detail.
How would Vedanta be able to assist me?
It is important to remember that the bank will not advise you on which option to choose.
We can support you by:
We are able to source independent SONIA and Base Rate caps from the panel of banks we work with. Please click here to view our article on independent interest rate caps.
Please get in touch with any questions you may have and a member of our team will be able to assist you.
You can reach us on 0207 183 2277 or at info@vedantahedging.com.
