S&P Global Ratings is examining how LIBOR discontinuation could affect ratings on instruments or transactions referencing LIBOR settings that terminate on Dec. 31, 2021. Regulatory solutions, such as the recently proposed "synthetic LIBOR" rate by the U.K. Financial Conduct Authority (see the glossary), combined with legislative support in the U.K., such as the proposed Critical Benchmarks Bill, are likely to reduce the risks of a disorderly transition at the end of this year.

But with any major market change, such as the LIBOR transition, it is not clear that these solutions will automatically and unequivocally apply in all situations and without challenge. In what we expect would be a limited number of cases, we could place our ratings on such issues on CreditWatch and subsequently suspend or withdraw them should the interest to be paid under the terms of the rated obligation remain unclear to us after the LIBOR benchmark ceases to be quoted. Because S&P Global Ratings is not a transaction party, we are not in a position to resolve ambiguities relating to applicable benchmark interest rates. Our ability to exercise analytical discretion or make qualitative judgments in applying our criteria does not extend to basic documentary terms, which our ratings are designed to reflect.

These potential rating actions are related to the U.K. Financial Conduct Authority (FCA) announcement on March 5, 2021, that the following widely referenced LIBOR settings will cease or no longer be representative:

• Immediately after Dec. 31, 2021, in the case of the sterling, euro, Swiss franc, and Japanese yen settings, and the one-week and two-month U.S. dollar settings; and
• Immediately after June 30, 2023, in the case of the overnight, one-month, three-month, six-month, and 12-month U.S. dollar settings.

The potential rating actions noted in this article focus on the non-U.S. dollar LIBOR settings mentioned in the first bullet above. They do not apply for the major U.S. dollar settings, in large part because those settings are not slated for discontinuation until June 2023.

The same principles regarding ratability and determination of interest rates apply for instruments that reference the U.S. dollar and other LIBOR settings that are scheduled for discontinuation in June 2023. However, we don't have observations at this point on how many issue ratings on these instruments could be affected.

For these debt instruments whose LIBOR settings will be discontinued in 2023, there is still time during which relevant market action could resolve any residual "tough legacy" language (see glossary). For example, we will observe whether federal legislation is passed, if a U.S. dollar synthetic LIBOR is developed, what replacement rates are used, and whether there are other developments. Nevertheless, absent regulatory and legislative solutions, the number of affected issue ratings is likely to be significantly larger, especially for debt issues that are difficult to amend, such as in structured finance.

Withdrawal Or Suspension Of Issue Ratings

Under our policies, we may withdraw a rating based on lack of sufficient information--such as lack of information relating to a rated obligation's interest rate. Information may be deemed sufficient only when there is sufficient quantity of information to enable the assignment of a credit rating, S&P Global Ratings has received such information on a timely basis, and S&P Global Ratings determines that the information received is reliable.

A suspension could occur if a rating committee lacks information of satisfactory quality to make a rating decision, but the issuer has notified the analyst whether the information will be available at a later stage--and if so, when--or the analyst cannot assess the information available or its impact on a credit rating but expects to be able to do so soon.

Given the similarity between suspension and withdrawal, it is more likely that we would initially suspend a rating due to unclear LIBOR successor language since we would expect that a benchmark rate will be declared or clarified. However, if we come to believe this is unlikely to be resolved, we would likely move to withdraw the rating.

It's possible that we could assign or reinstate ratings after a withdrawal or suspension if we subsequently receive sufficient information identifying the replacement interest benchmark and any related payment mechanics.

Failure to pay interest is a default and would be treated as such unless we believe there is a bona fide reason, unrelated to credit risk, interest was not paid. Failure to pay interest typically would be reflected in the issuer credit rating as well as the issue credit rating.

Focusing On Issue Credit Ratings

This article focuses on corporate, financial institution, insurance, and government (and related) entities issue ratings that are exposed to potential rating actions if there are no clear successor interest rate benchmarks identified once LIBOR is discontinued.

Issuer credit ratings, which are not the focus of this article, are typically assigned to corporate, financial institution, insurance, and government (and related) issuers. As we stated in "How To Say Goodbye To LIBOR Without Creating Market Chaos," Sept. 23, 2019, we could reflect any perceived lack of (issuer) preparation in our issuer credit ratings. We continue to monitor issuer preparedness with regard to LIBOR discontinuation, and, while it seems unlikely at this point, we could take rating actions on issuer credit ratings if we believe lack of preparation may affect issuer creditworthiness. Structured finance typically does not have issuer credit ratings.

We separately discuss the implications of a hybrid capital instrument being called upon discontinuation of a LIBOR benchmark rate and the issuer electing not to replace the instrument, in "Hybrid Equity Content When A Call On LIBOR Fallback Is Likely," published May 10, 2021. This could affect the equity content of hybrids for the issuer, and potentially issuer credit ratings.

Further, other articles (see Related Research) cover the potential impact of interest rate replacement on cash flows for transactions when the replacement results in a value transfer between a borrower and lender (or issuer and investor). Such impact is possible particularly in structured finance, as well as project finance.

In addition, structured finance assets' LIBOR benchmark discontinuation is not the focus of this article, but changes to the income being generated by assets under a successor rate could pressure our structured finance issue ratings. Asset inflows relative to financing costs could alter cash flows due to successor benchmark rates. Many legacy LIBOR-linked securitizations appear to have significant resilience against basis risk (see "Potential Effects Of LIBOR Replacement On U.K. RMBS Ratings," Sept. 1, 2021).

Likely Impact Of Synthetic LIBOR And The U.K. Benchmark Bill

Regulatory solutions, such as the recently proposed synthetic LIBOR by the FCA, combined with legislative support in the U.K., such as the proposed Critical Benchmarks Bill, are likely to reduce the risk of a disorderly transition at the end of this year.

Ambiguities relating to the interest rate that would be payable under these tough legacy contracts could be significantly addressed if synthetic LIBOR is successfully implemented and, in our view, is likely to reduce the number of issue ratings potentially affected by interest rate indeterminacy, assuming we receive the information. Nevertheless, synthetic LIBOR may not be adopted by all issuers or be applicable to all issuers whose LIBOR setting is being discontinued and may not be applicable in all jurisdictions where synthetic LIBOR could be a solution.

Issuers have made significant progress in 2021 moving away from LIBOR-related references. Some related debt issues have been redeemed early, and the LIBOR-based coupons of many others have been amended. But there are still debt issues whose fallbacks are weak and whose terms are impractical to amend. Where synthetic LIBOR is not adopted and fallback language is unclear or does not exist, we may still take rating actions based on a lack of sufficient information.

In either case, synthetic LIBOR, as currently conceived, would be in effect only until the end of 2022, though we understand it is contemplated that synthetic sterling LIBOR could be extended on a yearly basis for a maximum of 10 years. As such, for issues whose maturity extends beyond 2022, and if synthetic LIBOR is no longer applicable, the absence of fallback language or unclear fallback language may result in rating actions, even for issues where synthetic LIBOR is applied, as we approach the 2023 discontinuation of the remaining LIBOR settings. Synthetic LIBOR likely buys time for the issues referencing sterling synthetic LIBOR.

Impact On Issue Credit Ratings When A Replacement Rate Is Not Determined

We rate a financial obligation based on the promise within its documentation (or, in some cases, such as hybrid capital, based on the promise that we impute from the obligation's documentation). Our issue ratings are primarily opinions on the likelihood that a payment will be made in full and on time. For an obligation to be ratable, we look to the documentation to determine the timing of any payments and the amount that is payable on any interest and principal payment dates. Some obligations may not be ratable if we are not able to determine the interest rate terms. Tough legacy documentation language refers to documents that do not clearly identify the successor benchmark to a terminating interbank offered rate (IBOR) benchmark. If synthetic LIBOR and the U.K. Benchmark Bill do not resolve a tough legacy documentation weakness, we will likely place the ratings on those issues on CreditWatch barring any additional information received from issuers.

Absent subsequent receipt of amended documentation, clarification with regard to the applicability of synthetic LIBOR, or other additional information that clarifies the interest payment promise on the obligation, we may suspend or withdraw the issue rating after the relevant LIBOR benchmark terminates.

These concepts, described in "S&P Global Ratings Definitions," apply to our corporate and government ratings and structured finance ratings. In our ratings definitions, we state that as a general principle, we consider a promise ratable if it is credit-based and measurable.

We will seek to understand from issuers and transaction parties whose rated obligations utilize pound sterling, Japanese yen, or other LIBOR settings set to be discontinued on Dec. 31, 2021, whether they will apply synthetic LIBOR in all cases or other alternative rates will be implemented in advance of Dec. 31, 2021. This confirmation of new rates is needed because it is possible that for individual transactions, the documents may not be entirely clear as to whether synthetic LIBOR will be the replacement rate. Investor or transaction party disputes could also emerge at the time of transition.

Potential Isolated Issue Rating Actions Associated With The Year-End 2021 LIBOR Transitions

We reviewed the rated debt issues whose LIBOR settings are being discontinued on Dec. 31, 2021, to determine the expected impact of unclear LIBOR successor language. Our work suggests, in aggregate, the number of sterling, Japanese yen, and other LIBOR-linked corporate, financial institution, insurance, government, and related entities issue credit ratings that we could place on CreditWatch is likely to be less than 100, or substantially less than 1% of issue ratings. Similarly, we anticipate significantly less than 1%, or approximately 110, of structured finance issue ratings are at risk of being placed on CreditWatch. The number of issues is likely to decline as we receive more information.

To determine our estimate, we extracted from our database a list of rated debt issues that mature after 2021, pay floating-rate interest, and pay interest based on a LIBOR benchmark in the four currencies (Japanese yen, pound sterling, Swiss franc, and euro) that will be terminated by year-end 2021. In addition, our analysts have reached out to the issuers whose issues appear on our list to confirm the applicable interest rate benchmark and better understand issuer plans, if any, for possible documentation amendments.

Our analysis also suggests that the majority of issues potentially in scope of rating actions are from European issuers or non-European issuers issuing in a European market and are primarily issues in the sterling market and, to a lesser extent, the Swiss franc and Japanese yen markets. These are included in our estimate of potential issue rating actions indicated above.

We are not yet providing more specific numbers or publishing a list of potential issues in scope of CreditWatch placements because the situation may evolve as issuers continue to take action to prepare for the LIBOR discontinuations.

Of the structured finance transaction issue ratings, given the LIBOR settings being discontinued in 2021, most are related to U.K. residential mortgage-backed securities (RMBS). Similarly, of the Japanese structured finance transactions exposed to yen LIBOR settings, the majority is related to RMBS. We believe that transaction servicers are, in most cases, working to amend note coupons and assets away from LIBOR references before year-end 2021.

We think structured finance issue ratings generally may be more difficult to amend because trustees may not be able to locate and attain supermajority noteholder approval, which is typically required for material changes. In theory, amendments should be easier for corporate, financial institution, insurance, and government (and related) issuers given relationships between issuers and investors, but challenges persist--in particular, the potential for disagreement over the choice of updated benchmark and any associated spread adjustment, among others.

Potential Impact Of A Dispute, Trustee Action, Or Litigation Between Market Participants

We understand that LIBOR discontinuation may lead to dispute and litigation between issuers and investors. While each interaction would be unique, we would typically not withdraw or suspend a rating based on a dispute between issuers and investors where interest continued to be paid.

We think synthetic LIBOR and the companion Critical Benchmarks Bill upon adoption should significantly reduce potential litigation risks and the number of rated debt issues subject to rating action due to LIBOR discontinuation. Although there is no "safe harbor" protection from claims related to the use of synthetic LIBOR, there is a continuity of contract provision in the bill that provides that by law, contracts containing LIBOR that switch to synthetic LIBOR will be deemed to have always contained synthetic LIBOR. In our view, this should help to reduce the likelihood of legal challenges and clarify the treatment of synthetic LIBOR as a new rate from a legal perspective. However, the bill, upon implementation, would not apply to contracts governed by non-U.K. law, such as Japanese law.

We believe disputes remain possible based on how a replacement interest rate could affect the amount of interest being paid relative to what was paid under LIBOR. Synthetic LIBOR may produce unanticipated outcomes, at least for some transaction parties--for example, if the new rate on a residential mortgage that will reference synthetic LIBOR is higher than the borrower anticipated. In one hypothetical, it is possible that Term SONIA, one replacement rate, plus the ISDA recommended credit spread adjustment, could be 10 basis points to 20 basis points higher than the current LIBOR. We do not know how borrowers would react in such a scenario should it materialize.

Similarly, if an investor would now receive materially less interest than they would have under LIBOR, we would likely not take a rating action assuming payments are being made in accordance with the terms of the documents--even if with unexpected outcomes. But, if the assets in a structured financing generate materially less interest income, and this results in a substantial change to cash flows, we can envision investors disputing such an outcome. Also, investors or issuers could view the impact of a replacement rate as an unfair value transfer between the issuer and investors. This could also result in dispute. These potential disputes, should they materialize, would likely not result in rating actions as long as interest is being paid in accordance with the applicable documentation.

While not the focus of this article, for debt issues where we specifically estimate cash flow of assets relative to liability financing cost, any diminished cash flow resulting from synthetic LIBOR or successor to LIBOR would be assessed as part of our ongoing surveillance of issue ratings, most likely structured finance ratings.

Frozen Accounts And Escrow

If transaction funds are frozen because of investor dispute and this results in a default due to a failure to pay interest or principal, we would likely take the issue rating to 'D' (default). A failure to pay due to a dispute while cash is held in escrow might not lead to a 'D' rating but could lead to suspension or withdrawal since we would consider any escrow paid by the issuer. The timing of our decision will be influenced by market developments and how promptly we receive updated documentation or information pertaining to interest rate replacement or disputes.

Guaranteed Obligations

It's possible that an issue is guaranteed by another rated issuer and that the guarantor could elect not to make an interest payment under its guarantee because of a dispute between the issuer and the investors. While we consider that a guarantee can create a financial obligation for the guarantor, nonpayment of which would lead to a default by the issuer, we would apply the "Issuer Credit Ratings On Guarantors" section of "S&P Global Ratings Definitions." Specifically, we would not lower the issuer credit rating on a guarantor to 'SD' (selective default) in this scenario--if we were to view the commercial dispute as bona fide and that the failure to make payment does not reflect the guarantor's lack of willingness or ability to honor its financial obligation. Nevertheless, we would take the issue rating to 'D' if there is a failure to pay interest, unless there is a bona fide reason, unrelated to credit risk, for the nonpayment.

Imputing An Interest Rate Due To LIBOR Transition

We do not expect that we would impute an interest rate as a substitute for LIBOR when a successor to LIBOR is not clearly defined for existing obligations. In addition, if a structured finance instrument's coupon rate is based on the underling assets, which may vary over time, as described in the "Using Imputed Promises To Rate Debt Instruments" section of "S&P Global Ratings Definitions," we do not expect to impute an interest rate as a substitute for LIBOR for the underlying assets. (An example would be U.S. RMBS tied to the net weighted average coupon of the underlying assets.)

Potential Pitfalls Of LIBOR Successor Language

Debt issue documentation may contain pitfalls relating to LIBOR transition. One example is where the successor language states that the last quoted LIBOR rate becomes a fixed rate upon discontinuation of a LIBOR setting. Synthetic LIBOR could supersede that application of documentation. In this case, we would likely not place the issue credit rating on CreditWatch because we would assume the trustee is applying the correct application.

In another example, a bond may pay interest at a stated rate, which relies on LIBOR as part of its interest rate calculation. In this case, if the underlying (relied upon) LIBOR is terminating in 2021, and no successor is identified for the obligation, we anticipate treating this as we have described above and could place the issue credit rating on CreditWatch for a potential rating withdrawal or suspension.

Another example is where a bank polling process would have to take place to determine the successor to LIBOR. We would consider whether this is consistent with our ratability standard described in the "What Kind Of Promise Do Our Ratings Address?" section of "S&P Global Ratings Definitions"--in particular, we focus on whether the rate is readily accessible, is independent, and is calculated in a transparent way. If we view bank polling as inconsistent with these characteristics, we could place our issue credit rating on CreditWatch and subsequently withdraw or suspend it. We understand that synthetic LIBOR may prevent such older or weaker fallbacks from being applicable.

Unknowns Related To The End Of LIBOR

Despite years leading up to this moment, there is still uncertainty about how some events will play out. For example, it's possible existing successor language calling for fixed-rate fallback language may be challenged by those who believe it wasn't meant for permanent LIBOR discontinuation.

We understand there is a U.S. federal LIBOR assistance bill currently under discussion, Adjustable Interest Rate (LIBOR) Act of 2021, whose terms are likely to include a legal safe harbor, and New York law already provides safe harbor to reject and override fixed-rate fallbacks. The federal bill, if passed into law, is likely to reduce uncertainty and potential litigation. It would provide trustees a legal safe harbor to implement replacement rates and would reduce risk associated with LIBOR discontinuation for the U.S. However, legislative solutions won't address all situations. For example, many securitizations have a transaction party in place to select a successor rate, and legislation is unlikely to disturb such arrangements.

We believe the regulatory and legislative solutions are likely to help in the majority of cases. However, depending on the success of such initiatives, interest payments, both timing and amount, could be compromised for isolated debt issues because trustees are unsure about the payment to be made. This could be material to our issue ratings, especially in structured finance, where cash flow sufficiency could be compromised.

Related Publications

• S&P Global Ratings Definitions, Nov. 10, 2021
• European And Japanese Structured Finance Markets Approach LIBOR Cessation While U.S. Markets Prepare For A Major Shift, Nov. 2, 2021
• Potential Effects Of LIBOR Replacement On U.K. RMBS Ratings, Sept. 1, 2021
• LIBOR Transition: Laws Won't Eliminate All Uncertainty, May 14, 2021
• Hybrid Equity Content When A Call On LIBOR Fallback Is Likely, May 10, 2021