The Working Group on Sterling Risk-Free Reference Rates (the 'Working Group') has issued a Consultation Paper on the recommendation of a successor rate for certain legacy GBP LIBOR referencing bond contracts, including floating rate notes and securitisations, which will mature after the end of 2021.
What is in scope and what is not?
In scope:
• bond contracts where the contractual fallbacks are triggered in the event of the permanent cessation of GBP LIBOR (a 'permanent cessation event'); and
• bond contracts where the contractual fallbacks are triggered on an announcement of the non-representativeness of GBP LIBOR by the supervisor of the administrator of LIBOR (a 'pre-cessation event).
These types of contractual fallback provisions are most commonly found in bond documentation drafted after the speech by Andrew Bailey (then Chief of the FCA) in July 2017 on the future of LIBOR.
Out of scope:
• bond contracts where the contractual fallback is triggered by the unavailability of the reference rate at the relevant time, and which typically require quotes from a certain number of major banks in the interbank market to be sought to inform the rate to be applied; and
• bond contracts where market participants wish to actively convert LIBOR-linked bonds to a SONIA-derived rate at an earlier stage than on the trigger of the relevant fallbacks in the bond documentation.
Permanent cessation event and pre-cessation event fallbacks
The in-scope types of fallbacks in bond contracts are typically structured to operate such that upon the occurrence of a permanent cessation event or a pre-cessation event, an issuer is required to appoint an independent adviser to select (or to advise the issuer in the selection of) both a successor rate and a credit adjustment spread to be applied to such a successor rate. In each case, selection would be on the basis of the formal recommendations made by a relevant nominating body or, in the absence of such recommendations, customary market practice.
The Working Group (a relevant nominating body for these purposes) has formally recommended a credit adjustment spread methodology and has expressed a preference for SONIA as the risk-free rate for GBP LIBOR, but it has not recommended a successor rate for the purposes of these fallbacks.
If no successor rate recommendation were made for these contracts, determination of the successor rate would typically fall to the issuer or independent adviser, requiring them to exercise discretion, which could potentially expose them to challenge and litigation risk.
The Consultation Paper seeks feedback on whether it would be helpful for the Working Group to recommend a successor rate to GBP LIBOR for bonds upon the occurrence of a permanent cessation event or a pre-cessation event, and on the particular successor rate which ought to be recommended.
Overnight SONIA compounded in arrears v term SONIA
The Consultation Paper proposes two successor rate options - overnight SONIA compounded in arrears and term SONIA – and outlines potential considerations for these rates:
• Current usage in the bond market: All public SONIA-linked bond transactions issued in the sterling market use the overnight SONIA compounded in arrears. Existing infrastructure for, and familiarity with, this methodology and could reduce the risk of liquidity fragmentation in the SONIA-referencing bond market.
• Alignment with other products: Overnight SONIA compounded in arrears aligns with conventions used in the SONIA swap market and the fallback rate for derivatives, whereas term SONIA does not. Alignment with the derivatives market should reduce instances of amendment, or exclusion of instruments used to hedge bonds from the ISDA Fallbacks Protocol to reduce basis risk between SONIA compounded in arears and term SONIA, and would give methodology consistency for any future hedging of currently unhedged bonds.
• Working Group preference: Although the Working Group has consistently encouraged the use of overnight SONIA compounded in arrears, it has been working with the FICC Markets Standards Board (“FMSB”) to support development of a market standard for FMSB members in relation to an appropriately limited use of term SONIA reference rates. We can expect the proposed standard to be released for public comment later this month, and that could influence respondents' preferred successor rate.
• Economic and operational implications: Unlike for term SONIA (and LIBOR), for overnight SONIA compounded in arrears the interest rate and amount would not be known at the start of the interest period, which may have cash flow planning and systems implications for market participants. However, in the new SONIA-referencing bond market parties have adapted to not knowing the interest rate or amount until near the end of the interest period, and have changed systems to accommodate the new backward looking rate.
• Contractual implications: The extent and types of changes to contractual documentation will also differ depending on the successor rate, although the Working Group is of the view that English law-governed bond documentation containing permanent cessation event and pre-cessation event fallbacks generally allows for amendments of the type likely to be required to be made without recourse to bondholders.
• Alignment with FCA designated rate: a recommended successor rate may not align with the methodology for any synthetic LIBOR which the FCA may designate for tough legacy contracts under powers proposed under the Financial Services Bill (which we have written about here).
• Availability in other currencies: Term rates may not be available in all currencies however rates compounded in arrears will be available in all currencies where a risk-free rate is available.
• International consistency: For USD LIBOR legacy bonds the first waterfall step in the ARRC's recommended fallback language is to a term SOFR rate, which could create inconsistency, particularly for bond issuers using different currencies and reference rates, if the GBP LIBOR successor rate were to be overnight SONIA calculated in arrears.
• Treatment of underlying assets in securitisations: In securitisations, regardless of which successor rate might be recommended, the question of whether or not the reference rate for the underlying assets would switch to the same rate as the bond would need to be addressed, and consideration given to the implications for cashflows.
Next Steps
There are advantages and disadvantages for both possible successor rates. If, among other considerations, the feedback from market participants leads the Working Group to recommend overnight SONIA compounded in arrears as a successor rate it will be interesting to see if the Working Group also recommends conventions (such as the use of an observation shift) to be used in connection with that rate, or whether it will take the view that those are matters best left to issuers to agree on a case by case basis.
This Consultation Paper will remain open until 16 March 2021.
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