- It is not safe to assume that LIBOR will be available beyond December 31, 2021.
- To replace LIBOR, many players in the lending market have called for the development of forward-looking forward rates derived from approved, overnight, virtually risk-free rates (RFR) for each LIBOR currency. Like LIBOR, forward-looking RFRs would calculate the interest payable over an interest period at the start of that interest period.
- However, UK and US regulators, in particular, have pressured loan markets to switch from using LIBOR to using RFRs without waiting for the development of these forward looking RFRs, which may not be expected. not be available by the end of 2021.
- instead, regulators suggest borrowing from the recent practice of floating-rate sterling notes and using retrospective forward RFRs derived from a compounded average in arrears of all relevant daily RFR quotes relating to a period of interest.
- In July 2019, NatWest announced that it had made such a loan to National Express Group plc under a committed revolving credit facility. Further bilateral loans based on the RFR and made using a compound average of arrears followed.
LMA Exposure Drafts
In this context, the LMA published on September 23, 2019 “exposure drafts” of two single currency term credit agreements and revolving facilities (the Exposure drafts) this:
- indicate generally how these compound average RFR forward rates could be calculated and used in syndicated credit facilities; and
- are a way to consult the market on a number of issues related to the use of these RFR terms – lending market practices being insufficient for the LMA to produce recommended forms at this point.
An Exposure Draft concerns sterling loans; the other works with US dollars. The floating rate under the two Exposure Drafts is derived from the respective RFRs which are to replace Sterling LIBOR (SONIA) and US Dollar LIBOR (SOFR). As RFR quotes for an interest period are compounded and averaged in arrears, if interest is to be paid on the last day of each interest period, there is a need to find a way to compose and average all quotes. relevant before the end of each interest period. This is done using a staggered “observation period”.
In general, according to the lag method, all RFR quotes relating to an interest period are taken from a corresponding “observation period”. Each observation period is staggered (i.e. begins and ends X working days before the start and end of) the interest period to which it relates. This offset is used to perform all interest rate calculations and notifications:
- in the last days of the interest period; and
- in good time so that the debtor pays its interest bill on the last day of each interest period.
The usual latency period in the SONIA variable rate bond market is five working days. In loan markets, shorter terms may be adopted for short interest periods. In contrast, longer terms may be necessary, for example, for loans in the few developing markets whose exchange control regulations require substantial notice of the amount of each interest payment.
Under the Exposure Drafts, parties must choose between two pricing models. One of these models (in this article, the Adjusted RFR option) approximates the cost of funds to lenders using a credit adjustment spread known as the RR adjustment spread. This spread is separate from the line of credit and the compounded and averaged RFR. Under the other model (in this article the RFR Plus Margin Option), the lenders’ cost of funds (if factored in) is built into the line of credit itself, which is therefore likely to be higher than the line would be on a LIBOR-based loan or in as part of the adjusted RFR option in the Exposure Drafts.
Although exposure drafts predict that the RR adjustment spread will vary with the length of the interest periods, there is no consensus in the loan market, or LMA recommendation, on how how to calculate the difference between LIBOR and SONIA or SOFR, or how to calculate the RR adjustment. Spread. This currently makes the Adjusted RFR option somewhat moot.
None of the exposure draft pricing options are designed to compensate lenders for mandatory costs.
While the Exposure Drafts are clear about the general method of calculating the compound average using the lag method, they do not specify the equation to do so. The Financial Stability Board of June 2019 night RFR user guide provides examples of equations and helpful tips about them. As with other features of Exposure Drafts which are left to the parties for approval, this is because there is not enough market consensus on the underlying issues. When it comes to the compounded average, for example, there is no consensus on how or if RFR quotes should be compounded relative to weekends.
Exposure Drafts assume that the default source of the Compound Average RFR will be a screen rate published by a trusted third party (the Primary screen rate). Such a screen rate does not currently exist.
During any observation period where this primary screen rate is not available, the documents provide for the agent (or other willing financial party) to manually calculate the interest rate. This is known as the Compound rate of decline. Without a currently available primary screen rate, it is especially important that the parties agree on an equation for the compound average of the RFR that the agent or other relevant financial party is comfortable calculating.
Once a suitable candidate for the primary screen tariff exists, the parties may stop using the back-up compound tariff and request the agent to designate the candidate screen tariff as the primary screen tariff without changing the installation contract.
If parties are required to use the compound fallback rate, rather than the primary screen rate, but the necessary RFR quotes are not available for all or part of an observation period, there are options to respective fallback for transactions based on SONIA and SOFR. If SONIA quotes are not available, the fallback rate is derived from the Bank of England base rate plus an adjustment spread. If SOFR quotes are not available, the fallback is derived from the US Open Market Committee’s short-term interest rate target, plus an optional adjustment.
Fallback options do not include the use of benchmark bank rates, shortened interest periods, or interpolated rates similar to those found in the current LMA-recommended forms of facility-based agreements. LIBOR.
If the parties choose the adjusted RFR option, rather than the simpler RFR Plus Marge option (see The key pricing choice above), exposure drafts include lender costs of funds as a fallback if none of the other fallbacks are available or if there is a “market disruption”. say in a largely similar fashion to the LIBOR-based facility agreement.
When lenders opt for the RFR Plus Margin option, the LMA leaves open the question of whether these lenders should be able to claim an increase in their funding costs and, if so, what should trigger these claims and how they will. should be calculated.
In either pricing option, it is up to the loan markets to determine whether or how to compensate lenders for breach charges. The problems here include:
- It is not clear that lenders under syndicated loans always fund their holdings in wholesale markets from an interest period to an interest period, as many did before 2008.
- for most payments made before the last day of an interest period and its corresponding observation period, the interest rate applicable to this interest period will then not be known and will therefore not be available to fund the traditional variable-rate termination cost indemnity; and
- a simpler and more easily justified approach could be to charge debtors an administrative fee for any mid-term interest payment. This would generally involve compensating the financial parties for the administrative burden generated by the mid-term interest payments and discouraging debtors from making these payments.
Modification of existing installations
Since gross, daily, and overnight RFRs do not take into account bank credit risk or term risk, they are lower than the LIBOR rates they need to replace. When parties modify an existing facility to replace LIBOR with an RFR term, they will need to find a way to prevent this price differential from producing a transfer of value to or from finance parties or debtors. Financial markets have been working on how to prevent or mitigate this transfer of value over the past two years. The widely preferred option for doing this is to use the agreed credit spreads to quantify the relevant difference between the LIBOR and the particular RFR. As noted above, however, at the time of writing, there is no consensus in the loan markets on how these types of spreads should be calculated.
On October 25, 2019, the LMA released another document in the form of an Exposure Draft: the Reference Rate Selection Agreement (the RRSA). The purpose of the RRSA is to help streamline the process of replacing LIBOR with an RFR term in the many legacy transactions that last longer than December 31, 2021 (or any other date when it is necessary or desirable to replace LIBOR. ).
The RRSA plan is as follows:
- all parties to the old LIBOR-based installations contract whose benchmark rate is to be replaced will perform the RRSA;
- in the RRSA, these parties will make high-level selections from a set of pre-determined key options to modify the agreement on existing facilities;
- the RRSA will authorize the agent and the debtors to enter into a separate amending agreement amending the existing facilities agreement; and
- This amending agreement will bind all parties to the existing facilities agreement and will implement in detail the key high level choices made by all parties in the RRSA.
At the time of writing, the ECB has been publishing € STR (the RFR for the euro) for just over two months. Despite this, there are currently no plans to stop (reformed) Euribor.
Indeed, EURIBOR now looks so robust that the LMA is considering producing an exposure draft of a multi-currency facility agreement where the benchmark interest rates will be SONIA, SOFR, SARON (the RFR for Swiss francs) – and for loans in euros (and not in € STR but) EURIBOR.