LIBOR Update – Real Estate and Construction
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LIBOR has been a benchmark interest rate benchmark for many decades, used as the primary benchmark rate for several hundred trillions of dollars in derivatives, bonds, loans and securitizations. However, when the LIBOR manipulation scandal came to light in 2012, widespread problems with the reliability of LIBOR were identified.
As a result, the global regulatory community has introduced reform efforts to help restore public confidence in the reliability and robustness of benchmark rates, including LIBOR. Since then, the Financial Conduct Authority has announced that after 2021 it will no longer require participating banks to submit their LIBOR data. This largely means that from the end of this year LIBOR could be phased out and floating rate loans that currently refer to LIBOR should move to a floating rate based on ‘risk-free benchmark rates’ ( or RFR). In the case of pound-denominated commercial loans, the relevant risk-free benchmark rate is heavily promoted by the Pound Sterling Task Force (which was set up by the Bank of England to help develop bank rates. alternative benchmarks) is the Sterling Overnight Index Average (or SONIA).
This article examines the main differences between LIBOR and SONIA and how these rates may affect existing loans and new loans in the future.
Main differences between LIBOR and SONIA
There are three key differences between LIBOR and SONIA that will affect how rates are used to calculate interest on commercial loan facilities:
1. Historical vs predictive: SONIA is a retrospective daily rate. This is the interest rate paid yesterday on “risk-free” sight deposits between financial institutions as published by the Bank of England. In contrast, LIBOR indicates the rate at which funds are made available between certain banks for specific forecast conditions (eg one week, one month, three months, etc.). In short, LIBOR is based on a projection, while SONIA is based on historical data.
2. Calculation: Generally speaking, LIBOR is determined by calculating the average rate at which a group of specified leading banks can borrow funds from each other in the London wholesale lending markets. However, with SONIA it is determined by a compound average to reflect as a single percentage rate per year the cumulative effect of applying a series of individual daily readings of SONIA to any notional sum over a given period. .
3. Measured economic concept: SONIA is designed to be an (almost) risk-free rate. Consequently, SONIA does not include any credit or liquidity premium. In contrast, LIBOR is designed to provide an indication of the average rates at which submitting banks could obtain wholesale unsecured funding for specified periods and includes both a credit premium (to reflect bank credit risk over time) and a term liquidity premium (to reflect the risk). inherent in longer-term funding).
As these key differences demonstrate, the move from LIBOR to SONIA ultimately represents a significant shift in the debt financing landscape, and will alter the way interest on commercial loans is calculated, while requiring a change in debt. approach from the financial and treasury functions of borrowers.
What does all this mean for the calculation of interest?
Currently, the LIBOR element of interest calculated on a loan for any period under a loan facility (i.e., an interest period) is largely determined at the outset. of the relevant interest period on the basis of the corresponding prospective LIBOR rate. The interest payable for this interest period will therefore be known in advance. This ensures the certainty of cash flow for all parties.
This will in theory no longer be possible with SONIA, as it is a retrospective overnight rate rather than a published prospective rate. Instead, with SONIA, the floating item of interest for a period of interest is determined by reference to a composite average of SONIA during that period of interest. This gives rise to the problem that if interest is determined “in real time” during an interest period, the amount of interest payable by the borrower will not be known until the end of the interest period (or, in done, the next day). Since interest is payable on the last day of the interest period, this approach would not be practical or administratively applicable to lenders or borrowers.
In order to address this issue, the market is currently moving towards a ‘lagged approach’ in which the composite average of SONIA for a period of interest is calculated over a lagged period (often referred to as an observation period) that begins a specified number of days. (for example, 5 business days) before the first day of this interest period and ends the same number of days before the last day of this interest period. The net effect is that the compound average SONIA rate applicable to the Interest Period (and, therefore, the interest payable under that Interest Period) is known on the last day of the Observation Period, i.e. a specified number of days before the last day of the interest period. The purpose of this is to give the borrower sufficient time to organize the interest payment.
What happens with existing loans and legacy loans?
It would be desirable to review existing installation agreements as soon as possible to determine two key points:
1. Transition mechanics: The question is whether the loan facilities already include preventive provisions for the transition to SONIA and, if so, whether they are appropriate (and whether they will work in practice). For borrowers, special consideration should be given to any transitional arrangements that give their lenders a large degree of discretion to unilaterally impose a replacement method for LIBOR; and
2. Emergency arrangements: What are the relevant fallback provisions that will apply if LIBOR ceases to be available and an alternative rate is not adopted? In the absence of effective transitional arrangements and / or consensual transition, the variable rate component of syndicated and bilateral loans may fall on the cost of funds of each lender. This is problematic for a variety of reasons, including the difficulty of calculating the relevant cost to the lender of a particular loan.
Considerations for New Installation Agreements
When negotiating new installation agreements, there are a few things to consider:
1. Adjustment deviation: As the composite SONIA does not include any liquidity or credit risk premium, it will likely result in a variable rate lower than LIBOR. However, this means that lenders may seek to increase the spread or add a “credit adjustment spread” to cover the difference between SONIA and LIBOR in order to maintain their interest rate yield.
2. Operational and treasury functions: Borrowers and their internal treasury teams will have to ensure that new methods of calculating interest are recognized and regularize their systems in order to adapt to any new methodology of calculating and paying interest. In particular, even with the inclusion of observation periods, this transition may require more active and stricter cash management towards the end of the interest periods to ensure that there are sufficient funds to pay the obligations. interests. Borrowers should also be wary of differences in the methodology of calculating interest between different currencies depending on the relevant RFR and the fact that existing benchmarks are continually used (e.g. for loans denominated in euros, EURIBOR will continue to be published).
3. Break costs: Currently, stop fees are charged when borrowers repay an amount during an interest period, but with SONIA in theory this will no longer be relevant as loans will no longer be valued against a rate of prospective term benchmark interest. As such, lenders may charge additional or increased prepayment charges.
Conclusion
The shutdown of LIBOR was first announced in 2017, but the “market” approach to transitioning to a new RFR such as SONIA is still a complex and developing area. Even in a series of announcements and guidelines made as recently as March 5 by the FCA, the ICE Benchmark Administration (IBA) and the International Swaps and Derivatives Association (ISDA) have not provided definitive guidance on how all loans and derivatives will roll back. For example, one of the more notable announcements is that one and three month USD LIBOR will be released until June 30, 2023, while all parameters for GBP LIBOR will be released until December 31, 2021. The possibility that the The most common USD LIBOR and GBP LIBOR may nevertheless continue to be published using a “synthetic” methodology beyond these dates.
That said, while the desire to wait for market conventions to crystallize is understandable, time is running out at the end of the day. As such, to avoid unforeseeable pitfalls and exposure to unnecessary risk, we continue to advise our clients to remain proactive in their thinking about a transition away from LIBOR. This would include reviewing existing loan agreements as well as initiating an engagement with lenders and borrowing clients to agree on the best paths forward.
Originally posted by Cadwalader, Mar 2021
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought on your particular situation.