Loan market participants have been slow to adopt the more efficient approach to transition syndicated loans priced over U.S.-dollar Libor to a replacement floating-rate benchmark, but recently revised guidance and just-arrived conventions may fuel efforts.
A survey by Covenant Review published July 13 found no deals using so-called “hardwired” approach recommended by a key industry working group, in which a new rate is automatically determined by referencing a waterfall of choices.
Instead, about a third of the 288 new-issue and amended institutional loans that came to market in the first half of 2020 used language requiring loans to be individually amended when transitioned.
Melanie Gnazzo, a partner in law firm Chapman and Cutler's asset securitization department, said that her experience working on new or amended syndicated deals in recent months supports the survey’s findings. She noted seeing no deals that “hardwire in the replacement benchmark rate, because there’s skepticism,” less about SOFR (or secured overnight financing rate) than the corresponding spread adjustments needed to transition to it.
“In most loan syndications, the borrowers have a lot of leverage, and no borrower wants them want to be forced into pricing terms that are out of step with the rest of the market,” Gnazzo said. “So everybody is waiting to see where the trend line is going before they commit to something.”
The hardwired approach has been recommended by the Alternative Reference Rates Committee (ARRC), a private-market working group convened by the Federal Reserve and the New York Fed, that has been exploring new benchmarks for replacing the Libor standard when it is expected to end after 2021. The ARRC has provided guidance to move floating-rate cash transactions away from Libor to SOFR, a daily rate published by the New York Fed.
The ARRC has recommended both the hardwired and amendment approaches. The latter may be challenging, however, when Libor loses support as a benchmark after 2021 by the UK's Financial Conduct Authority - or perhaps even before then - requiring thousands of transactions to be amended simultaneously.
The issue of transitioning Libor-based loans to SOFR is highly relevant to managers of and investors in collateralized loan obligations (CLOs), since complications converting transactions to the new rate could adversely impact loans in the securitized pools.
Covenant Review notes in its survey analysis that it anticipates the market soon gravitating toward the revised version of the hardwired approach that was published June 30. That may start later this year, said Ian Walker, head of U.S. middle market research at Covenant Review.
“The pieces are now falling into place that allow for the loan market to start doing new deals using SOFR,” Walker said, adding, “Once the market is using SOFR as the new rate—even before LIBOR ends—then we’ll start to see participants getting more comfortable with having the hardwired language in the documentation that allows them to go straight from Libor to SOFR, without any negotiation.”
One such piece is the revised hardwired approach’s easier method to calculate “in arrears” the SOFR rate over a previous period to use at the end of the same-length future period. Libor enables borrowers to know precisely what future payments will be at the end of 30-day, 90-day or other terms. ARRC has yet to provide a term version of SOFR, but its stability has demonstrated that the arrears method provides an accurate estimate for what the rate will be at the end of the next interest period, reducing earlier concerns.
“You can estimate what your cash flow will be with a high degree of accuracy,” Walker said.
Another factor likely will be the ARRC’s conventions for how to calculate and use the new rate, published July 22. Those conventions clarify issues such as how to calculate the accrued interest using daily SOFR rates and how to incorporate the “spread adjustment” mechanism to bridge the differences between Libor and SOFR that the ARRC had yet to finalize when the fallback language was originally proposed.
“The spread adjustment is a major part of the economics of transitioning from Libor to SOFR, so now that it is finalized, the market will be more comfortable with the hardwired approach,” Walker said.
Gnazzo said that market participants are again discussing the transition away from Libor, after months of focusing instead on covenants and other issues more directly impacted by the pandemic, likely accelerating acceptance of the new rate.
“If market participants get comfortable calculating yields using SOFR in arrears, it would drive consensus and they could begin focusing on the spread adjustment and other corollary adjustments needed to maintain yield parity,” she said.
Walker said SOFR-related developments to look out for include the ARRC’s recently published conventions; and the readiness of vendor back-office systems to administer SOFR-based loans, by year-end according to ARRC’s recently published best practices; and with those factors in place the launch of new loans priced over SOFR.
At that point, banks are likely going to want to take advantage of the ARRC’s “early opt-in” option, to begin converting loans to SOFR before Libor ceases, perhaps unexpectedly sooner than anticipated.
“Even if you have the hardwired fallback in use, agents have quite a bit to do, including amending the credit agreement to reflect the changes so they can administer the new rate,” Walker said. “There’s work to do and things can go wrong, so you reduce risk by reducing your exposure to Libor."
