The floating-rate nature of loans is one of the distinguishing features of the asset class. Loans pay a two-part coupon – a fixed credit spread plus a floating market base rate. This base rate has historically been LIBOR, but that may change. The U.K.’s Financial Conduct Authority (FCA) has recently set the market abuzz with its announcement that it will no longer require banks to submit quotes for LIBOR rates in sterling by the end of 2021. The FCA also recommended that the market stop using LIBOR as a benchmark. This quickly turned to reports declaring the death of LIBOR and headlines clamoring over the uncertain future of LIBOR-pegged financial markets.
We believe that much of this has been overstated or a result of premature speculation. We’d like to establish a framework of “what’s what” to help investors understand this development, including what is known at this point and the potential implications for the senior loan and CLO markets.
As mentioned, the FCA announced that it will no longer require banks to submit quotes for LIBOR rates in sterling by the end of 2021, and recommended that the market stop using LIBOR as a benchmark. At this point the FCA announcement itself does not end LIBOR because the Intercontinental Exchange (ICE), which took over administration of LIBOR from the British Bankers Association in early 2014, could continue to publish the U.S. dollar rate. Whether it does or not, it does seem likely that ultimately the markets will adopt a replacement rate.
What are the implications?
First, it’s important to remember that there are nearly $350 trillion in financial products that reference LIBOR, including the derivatives market and the $4 trillion syndicated loan market. Given the size of the affected universe, an orderly transition to a new rate is something that will be carefully considered by all market participants, and likely to take at least five years, if not longer. Much of the transition discussion has so far been focused on the U.S. dollar derivatives market, but even there, LIBOR is not being phased out any time soon.
The Loan Syndications and Trading Association (LSTA) has done some analysis of the definitions of “LIBOR” in today’s credit agreements to determine the impact specifically on the syndicated loan market. The current definitions of “LIBOR” in agreements customarily provide for fallbacks in case the LIBOR screen rate is unavailable – most often U.S. Prime rate (Prime). Moreover, credit agreements customarily provide a “market disruption event” clause as a second fallback, which includes a trigger event entitling lenders to suspend making loans at interest rates calculated by reference to LIBOR. When triggered, all loans otherwise bearing interest calculated by reference to LIBOR become base rate or Prime rate borrowings. Admittedly, these fallbacks were designed for temporary disruptions rather than the discontinuation of LIBOR, but these clauses do provide relief and options for these events. However, given that Prime has been ~300 basis points above the Fed Funds rate over the past 20 years, and assuming that relationship holds in the future, we believe that issuers will be very motivated to amend their credit agreements to provide for an alternate rate. Fortunately, 4-5 years provides a lot of time for the loan market to renegotiate new wording and incorporate whatever new benchmark the broader swaps market chooses.
Another consideration is the impact to the CLO market – not only the largest investor base for senior loans, but a structure which utilizes LIBOR in its indentures to compensate debt investors. New issue CLO indentures have already started to include a provision that enables managers to select a new base rate, provided that the rating agency consents and certain classes of notes consent. While it would be hard for all existing U.S. CLOs to amend their indentures at once, it seems reasonable that managers will be able to add amendments before 2021. It’s good to remember that this isn’t the first large market interruption CLOs have faced in recent years. Volcker rule compliance and removing bond buckets in 2.0 deals was an arguably larger challenge, and the market was able to successfully adapt new issue deals and amend existing deals over the course of two years.
What alternatives to LIBOR are being considered?
In June, the Alternative Reference Rates Committee (ARRC) proposed a broad Treasury Repo Financing Rate (BTFR) as the new benchmark for derivatives and financial contracts. This rate is secured and should trade inside of LIBOR, which is unsecured. Lenders will not happily replace LIBOR with a lower base rate unless margins are adjusted accordingly.
Accordingly, the International Swaps and Derivatives Association (ISDA) proposed adding a spread to the BTFR to correct for the reduction in base rates. One problem with the BTFR is it is an overnight rate only. Issuers are accustomed to the ability to select among different terms which allows them to better align the base rate with principal repayments and to reduce interest costs. Further, switching from a term rate to an overnight rate might create operational burdens on CLO investors.
That being said, though there is no clear better alternative to LIBOR yet, it’s still early enough in the timeline that additional alternatives might surface. And as we mentioned, LIBOR is linked to much larger segments of the market, including OTC and exchange-traded derivatives, which are likely to lead the transition.
With a large runway to adopt and integrate any changes to credit agreements and indentures, and a history of adapting to significant market changes, we believe the senior loan and CLO markets should be able to transition a replacement rate for LIBOR without any material lasting disruption.
Past performance does not guarantee future results.
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