LIBOR transition in the UK — an unexpected first date with SONIA?

“Moving on” from LIBOR, an interest rate benchmark which underpins around $300T ($30T in GBP markets)¹ of financial contracts across derivatives, bonds, and loans was never going to be easy. Last month we, in the U.K., started to experience what life after LIBOR will look like, as the transition from LIBOR to the recommended replacement risk-free reference rate, the Sterling Overnight Index Average (SONIA) accelerated.

On 5 March, the Financial Conduct Authority (FCA) announced most GBP LIBOR settings will cease from 31 December 2021, after which representative LIBOR rates will no longer be available. From 31 March 2021 U.K. lenders will no longer offer new LIBOR-referencing loan facilities.

Many borrowers will have been aware of the proposed cessation date of 31 December. The FCA announcement amounted to confirmation of an already well-publicized target date. However, it is less likely that they were aware of the second date: the 31 March deadline, which is now upon us.

In practice, most U.K.-based lenders have been offering some new facilities on a SONIA basis since the latter half of 2020. Such new loans may not necessarily reference SONIA from day one, but, as a minimum, will incorporate a fixed transition date (usually the penultimate interest payment date (IPD) before year-end) and document details of the SONIA compounding calculations.

Consequently, most LIBOR transition negotiations to date have been included within new fundraisings or borrower-led requests for restatement or amendment of existing facilities. The commercial reason for some of these requests was often carve outs, or waivers, of financial covenants or extensions of facility availability periods and expiry dates due to the impact of COVID-19. As one might expect, this was particularly the case in real estate and corporate (trading) businesses with exposure to retail, leisure, and hospitality.

Bank-initiated transition discussions vary by lender. Communication, documentation, and, most importantly, timetables were inconsistent between banks. However, since January 2021, we have noted a marked acceleration in bank-led transition proposals across all sectors.

As result, a consensus is emerging on areas where borrowers should focus to ensure an efficient transition on market-facing terms: fallback language, the timing of the transition (pre or at the cessation of LIBOR), the calculation of SONIA itself, differing methodologies for the calculation of credit adjustment spreads (CAS); and the interaction of SONIA loans with interest rate floors and associated derivative contracts. The final point is notable as, in our experience, the priority of both lenders and borrowers has been on amending the underlying debt facility in preference to the ISDA and associated derivative contracts.

One misconception is the FCA announcement effectively fixed the credit adjustment spread for all derivative contracts and the 3M GBP LIBOR contract at 11.93 basis points — the five-year historic median of 3-month LIBOR and SONIA on 5 March 2021. This is not the case. It applies only to contracts subject to the ISDA fallback protocol. Furthermore, this did not set the credit adjustment for underlying loan facilities, although we have seen lenders seeking to apply this spread to loans also.

Borrowers now have two categories of loans: existing and new. Existing LIBOR facilities (and any associated derivatives) require transitioning to SONIA in advance of discontinuance or rely on, typically unsuitable, fallback language.

Perhaps certain borrowers, and indeed financial counterparties, did not think this day would ever come but this week marks the end of LIBOR for new borrowing. Some borrowers with smaller quantum debt facilities (commercial as opposed to corporate loans) are being offered Bank of England Base Rate as a LIBOR alternative, but for the majority it will be a move to SONIA. Furthermore, where new SONIA facilities are linked to current LIBOR facilities, for example a new tranche of a legacy LIBOR loan, restatement of the full facility to SONIA will likely be a credit condition of the new debt. Based on facilities we have arranged and reviewed, the 31 March cut-off date is being universally applied by banks, certainly UK-domiciled banks.

31 March 2021 may have crept up on certain sleeping market participants, but it is a wakeup call for borrowers and (certain passive) banks alike. SONIA is already here for new borrowing. Borrowers should proactively address transition now for remaining, existing LIBOR facilities. To avoid a messy break up with LIBOR and a difficult second date with SONIA in December.

¹ Source: Bank of England, "What you need to know about LIBOR transition"