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The finish line is in sight — GBP LIBOR transition

Date:
October 1, 2021
  • jackie bowie headshot

    Authors

    Jackie Bowie

    Managing Director
    Co-Head of Europe

    Real Estate | London

  • jamie macdonald headshot

    Authors

    Jamie Macdonald

    Managing Director
    Hedging and Capital Markets

    Real Estate | London

  • michael leslie headshot

    Authors

    Michael Leslie

    Director
    Hedging and Capital Markets

    Real Estate | London

Summary

As the date for the final GBP LIBOR fixing nears, the work from the banking and advisory community to transition all outstanding contracts from LIBOR to the new RFR is gathering momentum. We have previously published articles on the background to the transition and how borrowers should prepare. This short update is a selection of the most commonly asked questions we are receiving at Chatham and our answers.

How do I check the amount I am being charged and that my interest calculation is correct?

Some market data providers are offering online calculators for non-cumulative compounded risk-free rates (RFRs) which may assist borrowers in validating interest payments. Market data providers may require a sign-in to use these calculators, but they are offered free of charge, with the caveat that users should have calculations independently valued. Chatham offers a debt management solution to help our clients manage debt terms, payments, covenants, and other details. Our technology platform supports interest calculation/reconciliation and utilizes current market data and forward curves for purposes of these calculations.

Can I choose a different rate other than compounded SONIA?

There are not many other rates broadly on offer, and any alternate variable rate is unlikely to have a deep derivatives market.

Specifically for loans, there are some alternative rates available, but this varies by lender. The Bank of England (BoE) base rate is being offered by some U.K. based banks, although it tends to be for smaller borrowers only. Also, there is likely still to be a Credit Adjustment Spread (CAS) added to this rate.

Is there a forward-looking rate available which is similar to LIBOR?

There are some benchmark services that have started publishing forward-looking SONIA term risk-free rates. These are published in one-, three-, six-, and twelve-month tenors. Even with the existence of these term rates, the Sterling Risk-Free Rate Working Group (SRFRWG) considers that the usage of SONIA compounded in arrears will be used for over 90% of new loans, reinforcing it as the market standard.

I understand there is going to be a synthetic LIBOR rate; can I use that instead?

The Financial Conduct Authority (FCA) created synthetic LIBOR to address what it defines as ‘tough legacy contracts,’ where borrowers cannot practically obtain the necessary consents to add benchmark transition language to their loan documents. The FCA has been granted special powers to direct the administrator of LIBOR (currently ICE Benchmark Administration) to change the methodology for the calculation of LIBOR. This will lead to ‘synthetic LIBOR’ — term SONIA plus the spread adjustment (CAS).

The FCA made an announcement on 29 September on this topic which contained their decision that synthetic LIBOR (1-, 3-, and 6-month) could be used in all contracts (other than cleared derivatives). This will be subject to annual review, and the FCA reserves the right to impose further use restrictions in the future (beyond 2022). However, their language was firm in their statement around those looking to adopt synthetic LIBOR “we discourage the use of permanently unrepresentative benchmarks where appropriate alternatives are available. Users should seek to move away from using them”. Therefore, we expect transition to the SONIA compounded in arrears will continue for the majority of the market.

The FCA is now consulting, and so seeking responses, on this decision. The consultation closes on 20 October 2021.

There seems to be many ways to calculate the credit adjustment spread (CAS) — which one should I choose?

The established market approach for the CAS is based on the historical median over five years that calculated the difference between LIBOR and SONIA over five years of daily data points. The statement from the FCA on 5 March 2021 formally announced cessation of LIBOR and locked in the CAS based on this methodology (11.93 bps for the 3-month LIBOR interest period and 3.26bps for 1-month LIBOR interest period).

The alternative is to calculate the CAS on a forward-looking basis. This is the difference between the 3-month LIBOR swap and the 3-month compounded SONIA swap, and the calculation will be aligned with the maturity and profile of the loan. This leads to a very specific CAS for each individual loan and must be live priced in the market at the point of transition.

We have seen some borrowers opt for the fixed CAS (11.93 bps) on their swaps (as under their swaps they are receiving floating and paying fixed), but the forward-looking basis for their loan (which might be between 9–11bps) — thereby locking in a small benefit between the two rates.

As we get closer to the final transition date, we are seeing more borrowers opting for the fixed CAS. Lenders are increasingly offering only the fixed CAS to those borrowers transitioning at cessation (or the first IPD falling after 31 December 2021). So unless you are actively transitioning prior to this date you may not have the choice of the forward-looking CAS.

If I repay my loan and refinance to a new facility, can I avoid paying a CAS?

All new loans originated since end March 2021 have referenced the new RFR (SONIA), usually without the CAS detailed separately. However, this has, in some circumstances, been reflected in a higher lending margin than it might otherwise have been.

Also, with a new loan facility the other fees (arrangement fees, legal fees, security, etc.), would more than outweigh any ‘benefit’ which might be available.

What is the difference between cumulative and non-cumulative rate and why are they applied in different situations?

A cumulative compounded rate calculates the compound rate at the end of the interest period, and it is applied to the whole period. The compounded SONIA rate for loans is calculated using non-cumulative calculation. The non-cumulative rate for any given day is the cumulative compounded rate for that day minus the cumulative compounded rate for the previous day. It is important to note that either methodology will result in the same interest rate, and therefore interest payable, for the same notional over the same compounding period.

The non-cumulative basis is more suited to intra-period drawdowns and repayments and, therefore, standard in the banking (LMA) market, especially for revolving facilities or facilities that are not fully drawn at the point of transition. Conversely, cumulative compounding is more typically associated with the capital markets/bonds.

If I break the loan in the middle of an interest period, is the calculation different under SONIA versus LIBOR?

If a LIBOR-referencing loan is repaid in the middle of an interest period, the borrower would be expected to compensate the lender for the funding costs for the balance of the interest period. This is because lenders, in theory, are funding themselves on a matched basis using term rates in the interbank market. The use of non-cumulative compounded SONIA means that there should be no break costs applied when loans are repaid mid-period. Borrowers should however look out for small clauses which allow the lender to pass on ‘administrative’ costs of breaking loans mid-period.

I have a fixed-rate loan — do I have any actions for LIBOR transition? How are the break costs calculated?

A pre-existing, LIBOR-referencing fixed-rate loan (FRL) will continue to pay the same fixed rate for the contracted term of the FRL. However, the loan still requires updating to include IBOR transition language to account for the fixed rate either expiring or being terminated prior to the end underlying loan, at which point the fixed rate expires and the loan reverts to a floating rate (in all likelihood, SONIA plus a CAS).

Borrowers should confirm the calculation methodology and reference rate to be applied on the early termination of pre-existing FRLs. Particularly as no forward LIBOR curve will be available, the prevailing SONIA curve for the outstanding term of the FRL must be adjusted to maintain economic equivalence in termination costs.

I have a LIBOR floor in my facility agreement; how is this transitioned?

If you have a LIBOR floor in your Loan Facility, then it will remain in the SONIA facility. The current language we are seeing from lenders is that this loan floor will apply to the daily SONIA rate plus CAS (i.e., before it is compounded). This makes sense as loans accrue interest daily. However, this could potentially lead to a mismatch if you also have Floors within your derivatives. Under the derivative, the Floor applies to the compounded SONIA rate for the interest calculation period (Period Floor versus Daily Floor).

Can I transition before LIBOR ceases? When is the optimal time to transition?

You can opt to transition before 31 December 2021, although if your documentation is not already well progressed, it would seem unlikely you will transition much before the year end. We are seeing borrowers target documentation completion by the end of November, with the effective transition date (so the first compounded SONIA calculation) being their first interest payment date (IPD) in 2022.

What happens if I am not ready by the time LIBOR ceases on 31 December? What happens if I do nothing?

It is highly likely that your lender has already contacted you on this matter, given the impending cessation deadline and the regulatory pressure on lenders to transition existing LIBOR facilities and associated derivatives. This process has accelerated markedly in the last three months. However, in the event that you and your lender cannot agree to transition prior to cessation, you would be reliant on the fallback provisions in your current loan agreement. We strongly recommend that you seek independent legal and treasury advice if this is likely to be the case and are happy to advise you as is helpful.

My lender has made other proposed changes to my loan document as a result of the LIBOR transition; can I push back on this?

Unless there is a mutual agreement to restate and amend other aspects of the Loan Facility, there should be no other changes other than those related to the reference rate transition (and any repercussions of this including covenants compliance dates, etc.).

My lender is incurring legal fees to document this transition — who pays that bill?

There has been no directive on this from the regulator, but we have seen most U.K. banks pay their own legal fees. There have been some European banks who are offering to split the costs between themselves and the borrower. Chatham has seen one or two lenders who are passing the entire cost to the borrower. The latter is certainly not in the spirit of the transition guidance.

What fallback rates/language apply to SONIA loans?

Fallback language refers to document terms that are intended to be deployed in the event that the chosen RFR is unavailable.

While this should be much less of a risk in the new RFR world, it does need to be documented.

If cost of funds is adopted as a fallback, it is important to note that the LMA RFR guidance introduces a new definition of ‘cost of funds’ — and this is important for any market disruption provisions too. Borrowers’ legal advisors will be familiar with these changes and should look to incorporate them into the revised language. The idea of market disruption provisions to loans which are referencing RFR is still being hotly debated by the lawyers — the fundamental issue being that RFRs are not a proxy for term funding costs in the same way as LIBOR. We have seen some lawyers make a very strong case for omitting market disruption provisions completely.

What is the process for syndicated loans?

Compared to bilateral loans and club deals, syndicated loans being amended require the approval of the whole syndicate, or a specified majority, depending on the terms of the loan. Depending on the size of the syndicate, consents can be difficult to agree. The LMA did provide a template called RRSA (Reference Rate Selection Agreement) which suggested a two stage amendment process with the majority agreeing to the key commercial terms via a short checklist. The parties then delegate authority to the Agent and the borrower to implement the commercial agreement.

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About the authors

  • Jackie Bowie

    Managing Director
    Co-Head of Europe

    Real Estate | London

    Jackie is European Head of Real Estate and Co-Head of Chatham’s European business and a member of the Senior Leadership Team, with over 25 years’ financial markets expertise.
  • Jamie Macdonald

    Managing Director
    Hedging and Capital Markets

    Real Estate | London

    Jamie Macdonald is a Managing Director of Hedging and Capital Markets and serves as a senior leader on Chatham’s European Real Estate Team. He helps clients manage risk through derivatives and hedging activities.
  • Michael Leslie

    Director
    Hedging and Capital Markets

    Real Estate | London

    Michael Leslie is based in Edinburgh and specialises in debt advisory and debt-related hedging for our regional UK clients, primarily across the real estate and social infrastructure sectors.

Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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