First a confession. The title of this blog is slightly misleading and the details underpinning LIBOR transition are complex. However, the basic principles are relatively straightforward and hopefully the following guide will be useful in cutting through the mass of detailed articles currently appearing on this subject.
The key facts are:
- LIBOR is to be discontinued at the end of Q4 in 2021. There is no suggestion this date will change so we all need to be getting ready now and have an understanding of what this will entail.
- LIBOR will be replaced as a benchmark rate by what is termed a 'risk free rate' (or more accurately a near risk free rate). A RFR is a rate of interest an investor would expect from an absolutely risk free investment.
- The RFR chosen for this purpose is SONIA (the Sterling overnight index average). This is an overnight RFR published on a daily basis. The intention behind the selection of SONIA is to make use of a rate that is based on an active and liquid underlying market and to avoid the historical issues associated with LIBOR.
- To address the fact that LIBOR is a look forward rate whereas SONIA is a daily rate, a compounded SONIA rate is used.
- To further address the need for borrowers to maintain cash flow and treasury control, an observation or 'lag' period is in-built so that borrowers are aware of the amount of interest payable ahead of the payment date. 5 days is the norm for this purpose. This means that the actual amount payable will only be known 5 days ahead of the payment date rather than at the outset of the interest period.
- A term SONIA is being developed, and now published, but does not yet appear to be in use by the market.
- It is key to note that LIBOR is not a RFR and is not equivalent to SONIA. SONIA is lower than its LIBOR equivalent but borrowers will not simply pay SONIA plus margin. To create equivalency, a 'credit spread adjustment' needs to be built in. This is to account for (a) the fact that SONIA is an overnight rate and not a term rate and (b) the various premia included in LIBOR including a term liquidity premium and a bank credit risk premium. A mechanism for the calculation of such an adjustment therefore needs to be specified and most lenders have developed complex models for this purpose. This can be expressed separately or the margin adjusted to incorporate it. The intention is to create an equivalency of cost and return.
- We are already seeing SONIA based loan facilities being provided and the pace of adoption of SONIA under new facilities is accelerating. From the end of Q1 in 2021 no new Sterling LIBOR loans that expire after Q4 in 2021 should be entered into. However, many lenders are seeking to adopt SONIA as the benchmark rate ahead of this and borrowers can expect to start to see SONIA referenced in term sheets from now on.
- For new LIBOR based loan facilities, switch wording to SONIA will increasingly be the norm, providing for the mechanics for conversion ahead of end 2021 with the use of a median difference between Sterling LIBOR for the relevant interest period and SONIA over a 5 year look back period as the norm for determination of the credit spread adjustment.
- Transition agreements will also be required for existing LIBOR based facility agreements and lenders and industry bodies are working up mechanics and styles to address this.
- Ultimately, legislation may be needed to address the position under 'tough legacy contracts' but whether facility agreements, which normally included provision for the application of alternative rates of interest, will fall under this umbrella is unclear.
Chris Dun, Brodies LLP
2/10/2020
Contributor
Chris Dun
Partner
