The central assumption remains the same – firms can not rely on LIBOR being published after 2021. This was re-iterated on 29th April however in this most recent statement the deadline for the cessation of LIBOR loans was shifted 6 months to the end of Q1 2021. Given the unprecedented pressure on organisations caused by the current market turmoil, it is unlikely that there is a vast amount of management bandwidth to manage this task so the object of this article is to outline the key things to watch for and the detail behind them.
The three main points are:
- Changes to loans should be matched in the changes to derivatives used to hedge the debt
- The mark to market on the derivative should be substantially the same before and after being changed
- There is currently no SONIA volatility market so interest rate caps do not exist
Point 1a – mechanics of the loan:
SONIA is an overnight rate and presently, despite an intent to do so, there are no published term structure rates, so in order to have a rate for a 3 month period it is necessary to have the resets from the entire period to calculate the interest due on the interest payment date. In order to deal with the practicalities of this, typically, a look back approach has been agreed. In the case of the Associated British Ports bond that was issued in 2019, this is a 5 day look back. A look back was not an unprecedented approach as EURIBOR currently uses a 2 day look back as standard. Using the lookback method a borrower will know the amount to be paid on the IPD 5 days before the amount is due.
Point 1b – mechanics of the derivative:
The hedging derivative needs to match the loan and those considering changes to loans should always be mindful of the existing hedged position and the provisions of the loans that will undoubtedly require a similar hedge position to be maintained following any changes so the replacement rate language needs to incorporate a matching (5) day lookback. ISDA has defined the spread between LIBOR and SONIA as the median of the difference between the compounded term SONIA rate and the term LIBOR rate over a 5 year historic period. This will clearly differ for 12 month, 3 month and 1 month LIBOR etc. Additionally it will differ for a SONIA rate where there has been a basis shift (5 day look back) Indicatively the current spread for 3 month LIBOR is approximately 11Bps. This however is widening with the increased current spread between LIBOR and SONIA.
Point 2 – Value transfer
At all stages, before the application of any fees, the MtM of the derivatives should remain constant before and after the changes. This methodology should also be applied to the loan when considering any margin adjustments. Where banks are both lender and hedge counterparty this should be a simple process to achieve. Where different providers are used for hedging and lending this may require more work to achieve. As no market standard for loan look back has been set it may be the case that the approach differs between lenders and hedge counterparties meaning that a standard alteration of a derivative leads to a mismatch and inaccurate hedge for a loan. This area is something that should be carefully considered.
Point 3 – Interest rate caps
Whilst the Sonia derivatives market has increased significantly over the first quarter of 2020, according to ISDA data, there remains no option volatility market. This means that there is not a functioning way for SONIA based borrowers to hedge with a cap or for borrowers whose loans convert to SONIA to also convert their interest rate cap to a SONIA based cap. There is still time for this market to develop but it currently remains a gap in the process.
If you are restructuring debt due to Covid-19 it may be a good opportunity to get all the pain out of the way in one go and restructure to a SONIA loan. It is worth bearing in mind that SONIA is currently resetting at approximately 10Bps and with an ISDA spread to LIBOR of 11Bps a floating rate borrower will potentially be saving approximately 40Bps a quarter. This however is likely to be diminished by the lenders adjustment to the loan margin.
Jonathan Lye is a director at Auxilium Financial Risk Management