By end-Q3 2021 all legacy Sterling LIBOR linked loans expiring after the end of 2021 should be actively transitioned where viable. In order to achieve this milestone market participants should be considering the pointers set out in the Best Practice Guide published by the Working Group on Sterling Risk-Free Reference Rates ('Working Group').
Market participants should review their legacy Sterling LIBOR loan documentation and ask themselves the following questions:
Timing: how do we ensure all contractual amendments are negotiated and signed by end-Q3?
Early dialogue with counterparties is key. If the loans are syndicated the size and composition of the syndicate needs to be identified. Larger syndicates and syndicates with non-relationship lenders will likely take longer to transition.
Fallback provisions in the loan and their robustness need to be checked. Consider also the fallbacks in any hedging arrangements as these may operate differently to those in the loan documentation.
Check also the amendment provisions and, for syndicated loans, consent thresholds and consider whether any third parties such as guarantors or secured parties need also to consent to the amendment.
Replacement benchmark rate: which of our loans will transition to SONIA compounded in arears and which will require alternative rates?
This will depend on various factors, for example whether SONIA can be operationalised and provides enough notice of payment.
Alternative rates include the Bank of England’s base rate, a fixed rate and Term SONIA (for acceptable use cases). Alternative rates may be suitable, for example, for smaller borrowers seeking simplicity and payment certainty, or for market participants needing longer lead times to adapt to technology and process changes needed for SONIA compounded in arrears. If alternative rates are chosen, check whether suitable hedges are available.
Familiarise yourself with how the interest rate on your loan will be calculated post transition. The transitioned rate should be the sum of the alternative reference rate plus any credit adjustment spread (CAS) (to account for the difference between the alternative reference rate and Sterling LIBOR), with a margin added to this sum.
Borrowers and lenders need to discuss and agree how SONIA compounded in arrears is calculated and the conventions around it, and the practicalities of ensuring borrowers receive enough notice of interest amounts to make payments on time.
Effective date of benchmark rate change: when will our loans transition from LIBOR?
This is a matter for agreement between the parties, but must be no later than the first interest rate reset date after LIBOR cessation.
Credit Adjustment Spread: should we have a CAS and if so how should it be calculated?
The calculation for any CAS is for borrowers and lenders to determine. The Working Group does not make a recommendation but describes two possible methodologies: the five-year historical median approach and the forward approach. For more detail see the Working Group's paper on credit adjustment spread methods for active transition of Sterling LIBOR referencing loans here.
Whether or not the transition from Sterling LIBOR to the alternative reference rate gives rise to a transfer of value will determine the need for a CAS.
Floors: our legacy loans have a LIBOR floor – what does this mean for the transitioned loans?
Assuming the SONIA compounded in arrears is the chosen reference rate, the equivalent floor is SONIA + CAS. Where the sum of SONIA + CAS is less than the legacy floor value, the Working Group’s recommendation is for the CAS to remain unchanged, with SONIA adjusted to ensure that the aggregate of SONIA + CAS is equal to the legacy floor value. Whether or not legacy floors should continue and their terms are commercial matters for parties to agree.
For more detail on floors see the Working Group's Detailed Loan Conventions paper here.
Documenting transition
Even once the commercial points have been agreed between the parties, transitioning a Sterling LIBOR loan will require an amendment agreement and, depending on the nature of the loan facility arrangements, the impact on existing security documentation and guarantees may need to be analysed and legal opinions required.
In addition to the issues for consideration mentioned above, the amendment agreement will need to deal with the selected interest periods, fallback provisions to a replacement reference rate, whether or not break costs should apply, and alignment of prepayments notice periods with the lookback period (for SONIA referencing loans).
Any interest cover or debt service projections, and the economic assumptions around interest rates in financial models may need to be reviewed.
Being transition-ready requires preparation, active engagement with counterparties, and engagement of legal expertise. Market participants are encouraged to transition early to ensure a smooth, efficient and effective transition experience.
