European structured finance issuers will be ramping up their efforts to phase out British pound sterling LIBOR this year, ahead of the Dec. 31 deadline. To minimize any credit impact on structured finance transactions, references to sterling LIBOR will need to be replaced with alternative benchmark interest rates, typically risk-free rates (RFRs), and suitable credit spread adjustments for both assets and liabilities.

Structured finance issues are sensitive to the interest rate transition process because their transaction terms typically allow for a limited scope of changes after closing. Implementing significant amendments often requires agreement by a wide range of parties, including transaction participants and noteholders. The risk of payment disruptions generally varies with the level of operational complexity in setting the note coupon if LIBOR is discontinued altogether. Even so, the European structured finance market's progress in moving away from LIBOR has outpaced the U.S. market, as the Sterling Overnight Index Average (SONIA) is now a popular alternative for new issuance.

However, challenges remain this year, including how to handle "tough legacy" contracts, or contracts that have no realistic ability to be renegotiated or amended. In addition, about half of LIBOR-exposed asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) transactions feature interest rate hedges, which will need to be amended to accommodate the replacement rates.

SONIA Usage Is Now Widespread For New Issues

Since 2017, the Bank of England's Working Group on Sterling Risk-Free Reference Rates has considered SONIA the preferred RFR for sterling markets. Because SONIA rates are fundamentally different from sterling LIBOR, the transition is more complex than simply substituting one rate benchmark for another. LIBOR is a term and forward-looking rate while SONIA is an overnight rate, which requires compounding and a lookback period (until a term SONIA rate is available). Additionally, since LIBOR is not an RFR, it has historically exceeded compounded SONIA by a risk premium that reflects bank credit risk. On a long-term mean basis, the gap has been approximately 15 basis points for the one-month maturity between sterling LIBOR and compounded daily SONIA.

Converting LIBOR to SONIA on a financial contract requires a credit spread adjustment to avoid value transfer between the lender and the borrower. We believe that minimizing value transfer will help prevent disputes. Market participants and regulators have had multiple consultations to form consensus on the credit spread adjustment methodology. Still, based on our discussions with market participants, challenges remain. Some servicers raised concerns that the working group's recommendation to use a five-year historical median to set the spread may not preserve the economic value of the contracts, considering the current ultra-low interest rate environment and the difference in weighted-average life between transactions.

Although a term rate for SONIA is not yet available, new structured finance issues in Europe have been widely using the benchmark since 2019, which has boosted market confidence. This is in contrast with the still-low usage of the Secured Overnight Financing Rate (SOFR) in the U.S. dollar-denominated structured finance market, where the lack of a term rate is often cited as a reason.

Daily compounded SONIA in arrears with a five-day lookback period is widely used as the coupon benchmark for sterling-denominated ABS and RMBS. By end-2020, we had rated 71 sterling structured finance issues linked to SONIA, worth £56 billion, including legacy issues novated from LIBOR to SONIA. In 2020, all rated floating-rate sterling issuances referenced SONIA. For comparison, we have so far rated no U.S. dollar structured finance issues linked to SOFR.

Further Regulations Expected For "Tough Legacy" Contracts

With the deadline approaching, the clock is ticking for LIBOR replacement on legacy transactions. In the last quarter of 2020, 16 rated ABS issues from two different securitization programs were novated to replace sterling LIBOR with SONIA. We expect the conversion process to accelerate in 2021 and encourage transaction parties to inform us of their transition plans as early as possible (see "Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested," published on Jan. 13, 2021).

One complex issue that continues to be discussed is replacing benchmark rates in legacy financial contracts. U.K. regulators and market participants held a key consultation, which ended on Jan. 18, 2021, related to the Financial Conduct Authority's (FCA) ability to approve a so-called "synthetic LIBOR", under proposed amendments to the Financial Services Bill. This could be used in "tough legacy" contracts, or contracts that have no realistic ability to be renegotiated or amended. A synthetic sterling LIBOR would be designed to provide a reasonable approximation for sterling LIBOR after 2021, while it would not, by any means, restore the representativeness of the outgoing benchmark.

However, how to define "tough legacy" contracts remains an open question. Based on the latest FCA announcement, these would include loan contracts that failed to obtain borrower consent to change the benchmark rate or note issues that did not obtain a mandatory noteholders' consent to convert the coupon rate. Despite this announcement, market participants are waiting for a more precise definition, and their ability and willingness to use synthetic sterling LIBOR on eligible contracts remains uncertain. The use of synthetic LIBOR outside the U.K. market is also questionable. We expect further consultations later in the year to provide greater clarity.

Fallback Provisions Determine Feasibility Of Setting Coupon Rates

As of end-2020, we rated 170 issues linked to either sterling or U.S. dollar LIBOR in the Europe, Middle East, and Africa (EMEA) region. Most of these transactions are backed by assets that were originated in the U.K., and RMBS represents the largest exposure in our surveillance portfolio (see chart 1).

Chart 1

For these transactions, we reviewed the viability of determining the note coupon rate after LIBOR is phased out based on two factors: the liability fallback language categories and the ability to amend transaction documents.

Liability fallback language categories

For each transaction, the note terms and conditions define LIBOR and provide a decision-making chain that the appointed agent, acting on the issuer's behalf, would follow to derive the LIBOR applicable on a given determination date. Most transactions follow this path:

• The agent uses the British Bankers Association's interest settlement rate widely quoted on the screen page, called the screen rate.
• If the screen rate is unavailable, the agent would request the quotes from the reference banks and determine the applicable rate based on the arithmetic mean of the offered quotes or another calculation method set up by the documentation.
• If the screen rate is unavailable and no quote is provided by reference banks, the agent would set the note LIBOR at the predecessor determination date.

Based on the ultimate LIBOR-setting option if the screen rate is unavailable, we have identified five fallback language categories as described in the table below, ranked from weakest to strongest.

Chart 2

Ability to amend transaction documents

We analyzed transaction-specific conditions for replacing the note reference rate and the noteholders' consent requirements.

According to the recommended AFME language, the note trustee would agree with the issuer to modify the applicable benchmark rate on the notes without the noteholders' or secured creditors' consent if certain conditions are triggered, including the indefinite discontinuance of LIBOR as the current benchmark rate. The only time the modification would not be made is if more than 10% of the holders of the senior-most class of notes objected during the notification period, though it could still be agreed by an extraordinary resolution. We view this form of noteholder approval as a type of "negative consent." Clearly, it places less of an operational burden on issuers compared with options that require explicit noteholders' consent, making the transition process easier from that perspective.

For most transactions that closed before 2018, a change in interest-rate setting constitutes a "basic terms modification," which the affected noteholders must approve as an extraordinary resolution. The quorum for passing an extraordinary resolution typically requires the votes of 75% (or, in some limited cases, 66.7%) of the affected noteholders. Compared with the U.S. market, where 100% of votes are required, passing an extraordinary resolution is a more feasible process for U.K. transactions. This underpins our expectation that most sterling LIBOR-linked issues will convert to an RFR during 2021.

LIBOR Phase-Out Will Affect U.K. RMBS The Most

RMBS makes up 55% of our EMEA surveillance portfolio exposed to LIBOR. At end-2020, we rated 102 RMBS issues tied the note benchmark rate, comprising 426 classes linked to sterling LIBOR and 18 linked to U.S. dollar LIBOR.

Our review of the note terms and conditions for RMBS revealed a high degree of uniformity in the fallback language and the noteholders consent required for the benchmark replacement. All of the transactions feature either bank polling or LIBOR fixing as a fallback, and the wording of relevant note conditions is very similar, if not identical, within each category. None of the RMBS issues feature transaction party discretion on the applicable rate. Most legacy issues will solicit noteholders' consent for replacing the benchmark rate.

When the screen rate is unavailable, 63 issues--all of which closed prior to mid-2018--would enable fixing the LIBOR coupon at the last quoted LIBOR under the terms of the transaction documents. A change in the coupon benchmark is commonly treated as a basic terms modification, subject to the noteholders' approval in an extraordinary meeting, with a 75% quorum for each affected class.

Nineteen RMBS issues, which closed in 2018 or 2019, adhered to AFME language, enabling a smoother conversion to an alternative rate, subject to a negative noteholders' consent. All rated sterling floating-rate U.K. RMBS issues placed from 2020 onward are already linked to daily compounded SONIA.

There are 20 RMBS issues in our portfolio with relatively weak LIBOR fallback contingencies: they rely on bank polling as the ultimate remedy and will solicit approval from at least 75% of the noteholders for replacing the benchmark rate. In our view, these transactions would be the most pressured to convert to an alternative rate this year in order to minimize payment disruption.

Chart 3

Chart 4

U.K. RMBS Servicers Weigh In On LIBOR Transition

The conversion from LIBOR to RFRs can introduce structured finance notes to basis risk. This risk has several sources, including the size of credit spread adjustments, timing gaps between rate conversion on the assets and liabilities if the transition affects both, and amended swap terms for hedged classes. Additionally, expenses related to the rate transition can add to senior transition costs. To assess the potential rating impact for each issue, we analyze these factors individually as we become aware of the amended transaction documentation. Since junior tranches are typically more dependent on excess spread than senior tranches, they would be most sensitive to basis risk arising from rate conversion.

In the fourth quarter of 2020, we asked U.K. RMBS servicers about their LIBOR transition plans for the notes and the underlying mortgage contracts.

Conversion on coupon rates hindered by credit adjustments

For the note coupon rates, most servicers said they intend to replace LIBOR with daily compounded SONIA in arrears as the market standard for U.K. transactions during 2021. For some legacy transactions, the aim is to exercise the call option this year before the LIBOR phase-out.

Servicers said that the most challenging aspect, which may slow the transition, relates to sizing a credit adjustment spread in order to minimize the economic impact. For the transactions that require explicit consent from the noteholders to approve the new RFR, servicers believe the approval process may take between one and three months.

Modification to asset reference rates is pending further regulatory guidance

While some servicers plan to start borrower notification in the first quarter and aim to complete conversion within a few months, others indicated they would wait for further FCA guidance on "tough legacy" contracts and decide on a definite course of action around mid-2021. Switching to an alternative rate may depend on the underlying contracts: if the conversion is only possible upon LIBOR cessation, then the transfer can only happen after year-end, unless the FCA explicitly allows an earlier start date.

Unlike structured finance liabilities, there is no market standard on the new reference rate that will replace LIBOR on underlying loan contracts. Depending on the servicer, converted loans will follow the Bank of England Base Rate (BBR) or a standard variable rate pegged to BBR.

Synthetic LIBOR is considered the last option if conversion to an alternative benchmark fails. Some servicers think that there may be legacy contracts that could adopt synthetic LIBOR after December, though on a limited scale. Also, some servicers may consider using term SONIA rates in the loan contracts when such rates become available and widely used in the market. Most servicers said that their ultimate strategy will be largely driven by further market consultations and regulatory guidance, as well as considerations of consumer protection and litigation risks.

Timing mismatch between notes and assets conversion can introduce basis risk

Based on servicer feedback, we expect the asset rate conversion to lag the coupon rate transition for more than half RMBS transactions. This is due to the time it takes to develop and implement a borrower notification strategy and regulatory considerations. Services expect this to be a multi-stage process this year and possibly even beyond 2021. Even if the LIBOR transition does not lower excess spread, some RMBS issues may see temporary exposure to higher basis risk than in the pre-transition period, leading to a negative rating impact.

Swap contracts are likely to be adjusted on a bilateral basis

Nearly half of outstanding LIBOR-linked U.K. RMBS notes that we rate are hedged with swap or cap agreements that cover basis risk or foreign currency mismatches, or both.

Chart 5

The 2006 International Swaps and Derivatives Association (ISDA) definitions contain fallback language for U.S. dollar and sterling LIBOR in case the screen rate is not available for each floating-rate option, effectively, key transaction party discretion or bank polling. The original provisions were developed to address temporary rather than permanent LIBOR discontinuance. In October 2020, ISDA launched the IBOR Fallbacks Supplement to the 2006 ISDA Definition that incorporates the new fallback provisions. This became effective on Jan. 25, 2021, for those parties that adhere to the fallback protocol or otherwise agree on a bilateral basis to include the new fallbacks in swap contracts.

Based on our conversations with the servicers, most transactions aim to amend swap agreements on a bilateral basis with the involved counterparties. Modifying the terms of a swap agreement usually requires noteholders' notification but not a prior explicit noteholders' consent; the exact process is defined on a case-by-case basis in the note terms. The common intention is to align timing and terms of swap amendments with the rest of changes to the transaction documentation. The need to amend hedge contracts may create an additional delay in the transition process, and the amended swap terms will be one of the key cash flow considerations when assessing the rating impact on the notes (see "Credit FAQ: SONIA As An Alternative To LIBOR In U.K. Structured Finance Transactions," published on Feb. 6, 2019). We believe that adherence to the new ISDA fallback protocol is unlikely.

Other Asset Classes' Transition Plans Are Mixed

For all other asset classes, our portfolio of LIBOR-linked transactions includes 24 ABS comprising 44 rated classes of notes, 21 structured credit transactions, 18 CMBS, five corporate securitizations, and four covered bond programs.

ABS exposure to LIBOR cessation keeps reducing

In fourth-quarter 2020, 16 of the 24 issues were novated to replace LIBOR with daily compounded SONIA, and the novation did not lead to any negative rating actions. Only one of the outstanding issues has bank polling as an ultimate fallback provision, and it is set to redeem this year. Additionally, one transaction enables LIBOR fixing, but it does not describe the required form of noteholders' consent for replacing the coupon benchmark rate.

Sixteen of the 24 issues contain AFME-compliant LIBOR fallback contingencies. Six more seasoned transactions, which closed between 2012 and 2017, enable LIBOR fixing while soliciting the noteholders' voting on the new benchmark with a 75% quorum.

Unlike RMBS, most ABS transactions are collateralized with fixed-rate assets and are therefore not exposed to LIBOR on the asset side. This limits basis risk related to timing mismatch of LIBOR conversion for the assets and the notes.

Half of the LIBOR-linked ABS classes are hedged, comprising 20 sterling-denominated tranches and one dollar-denominated tranche. For these, the need to amend swap contracts is an important factor to consider in the conversion process.

Chart 6

Chart 7

Structured credit fallback provisions show high variability

Of the weaker provisions we observed, nine issues include a combination of bank polling with an extraordinary noteholders' meeting to approve the transfer to an RFR, requiring 75% or 66.7% of voters. One transaction includes LIBOR fixing with 100% noteholders' quorum required to switch, and another issue outlines bank polling with no defined form of noteholder consent.

We observed stronger fallback language in other transactions, with six cases of LIBOR fixing and a 75% or 66.7% quorum for transferring to an RFR; two cases of LIBOR fixing with no defined form of noteholders' approval; one case following AFME language; and one case of note coupon setting at the key transaction parties' discretion in combination with a switch to RFR subject to a negative noteholders' consent.

Half of our rated structured credit issues exposed to LIBOR are repackaged securities, with the underlying collateral also linked to LIBOR. As these transactions have no excess spread, synchronization of the transfer to an RFR on the assets and liabilities is key to limiting potential cash flow risks.

Chart 8

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All CMBS transactions enable LIBOR fixing, while replacement process varies

According to the provisions for nine issues, all of which closed before mid-2014, LIBOR can be fixed at the last available date when the LIBOR screen rate becomes unavailable, but there is no specific language regarding the transfer to an RFR.

Four transactions enable LIBOR fixing and transfer to an RFR subject to the negative noteholders' consent with a 10% or 25% quorum threshold, which is the least risky solution.

In five transactions, LIBOR can be fixed as that at the last available date, and the issuer would hold consultations with the noteholders on the new RFR in any manner it deems fit, with no explicit voting or negative consent by the noteholders formally required. In most transactions, the consultation period is limited to 10 days. It is difficult to opine on whether noteholder consultation would be an operationally more efficient form of consent compared to a formal noteholders' meeting, as this is largely dependent on the concentration of bond ownership, in our view.

Chart 10

Corporate securitization issuers will solicit noteholders' approval in transition to RFR

We rate five U.K. corporate securitizations with sterling LIBOR floating-rate notes. For two, fixing LIBOR is the ultimate remedy, while the remaining three rely on bank polling. In either case, transferring to a new RFR would require an explicit noteholders' approval by 75% of the quorum for all of the notes. As corporate securitizations are typically closely held among few investors, reaching the required quorum could be easier compared with more broadly held issues in other asset classes.

We rate a further two U.K. corporate securitizations, AA Bond Co. and RAC Bond Co., that contain LIBOR-indexed bank debts that rank pari passu to rated senior notes, making the rated notes indirectly exposed to the revised terms upon LIBOR discontinuance.

Covered bonds expected to have a smooth transition

We rate four covered bond programs with exposure to sterling LIBOR, three of which will be redeemed before December or will use the last LIBOR rate as a reference rate for the notes redeeming in early 2022. The issuer of the other program has confirmed their intention to replace LIBOR before the end of 2021.

As covered bonds are backed by the general obligations of the issuing banks, which are all expected to stay solvent in the short term, maintain long-term issuer credit ratings in the 'A' category or higher, and remain actively involved in their debt management, replacement will be implemented through a consent solicitation process with the noteholders. Issuers may be offering a small premium on the notes to compensate for switching costs on top of a credit spread adjustment, in line with past precedents. We therefore do not expect any setbacks in the transition process.

Related Research

• Early Notice Of Interest Rate Changes For Structured Finance Transactions Due To LIBOR Transition Requested, Jan. 13, 2021
• SOFR Emerging As Alternative To LIBOR In U.S. Debt Markets, Dec. 4, 2020
• As The Deadline For The Transition From LIBOR Approaches, Work Remains For U.S. Structured Finance, Oct. 6, 2020
• Credit FAQ: How To Say Goodbye To LIBOR Without Creating Market Chaos, Sept. 23, 2019
• Credit FAQ: SONIA As An Alternative To LIBOR In U.K. Structured Finance Transactions, Feb. 6, 2019