Understanding the LIBOR Transition

The announcement of LIBOR cessation would trigger the spread adjustment to be fixed as a component of the LIBOR fallback rate for derivatives contracts with fallback provisions governed by ISDA. For legacy non-consumer cash products referencing USD LIBOR, this fixed spread adjustment would be added to a form of SOFR to replace USD LIBOR as recommended by the ARRC. Despite the potential delay of USD LIBOR cessation to mid-2023, U.S. regulators are encouraging no new USD LIBOR contracts after the end of 2021, while allowing most legacy contracts to mature before USD LIBOR stops.

On derivatives contracts, progress has been made in LIBOR transition with the ISDA 2020 IBOR Fallbacks Protocol having taken effect on Jan. 25, 2021. The other milestone in listed derivatives’ LIBOR transition also took place on Jan. 25 when CME provided details on proposed methodology for transitioning Eurodollar futures and option contracts. On cash products, the ARRC has recommended fallback language for floating-rate notes, bilateral business loans, syndicated loans, and saucerization products for market participants’ voluntary use.

In June 2023, the U.S. dollar London Inter-Bank Offered Rate (LIBOR) will likely be discontinued. The Alternative Reference Rates Committee has identified the Secured Overnight Funding Rate (SOFR) as the recommended alternative reference rate to replace USD LIBOR.

SOFR is calculated as a volume-weighted median of transaction-level U.S. Treasury repurchase agreements data, reflecting borrowing cost in overnight borrowing collateralized by U.S. Treasury securities.

One difficulty is that in the absence of SOFR-based term rates, SOFR compounded in arrears currently is the preferred replacement rate in many products. Calculated over the current interest period, it leaves little notice time before payment and poses significant operation disadvantages for some cash products.

Japanese securitizations could find losing LIBOR laborious.

Japanese yen LIBOR announcements will be discontinued at the end of 2021; discussions on replacements among securitization transaction parties are accelerating in Japan.

The LIBOR transition may have been extended, but it's not going away. U.S. regulators have indicated that banks should stop using LIBOR in new issue contracts by December 2021. This means the leveraged loan and collateralized loan obligation (CLO) markets are expected to see significant changes in interest rates during 2021 as borrowers and lenders come to terms with new risk free rates, such as SOFR, together with spread adjustments, floor considerations, and related changes.

Legacy CLO transactions should have additional time to make the shift toward new rates based on the recent announcement from the Financial Conduct Authority that most dollar LIBOR settings will cease after June 2023. At year-end 2020, S&P Global Ratings had about 870 rated U.S. CLOs from 140 managers outstanding, with origination dates ranging from 2006 through Dec. 30, 2020. Within these CLO indentures, there are a variety of document provisions related to how a potential LIBOR transition should be handled.

The transition from the British pound sterling London Interbank Offered Rate (LIBOR) is gaining momentum in Europe's structured finance market, ahead of the phase-out date at year-end.

S&P Ratings expects the transition process across rated transactions to speed up this year, though with significant variation.All of the affected European structured finance notes that S&P Global Ratings rates contain fallback provisions that allow for replacement of the benchmark rate. For seasoned transactions, replacing LIBOR generally requires explicit consent from three-quarters of the noteholders, which seems feasible in practice.

However, about 20% of transaction documents contain relatively weak fallback provisions, which could lead to payment disruption if the benchmark is not replaced before the LIBOR end date. Questions also remain for legacy contracts, especially individual loan agreements contained in the underlying collateral, which was mostly originated in the U.K.