By Tal Reback Nov 15, 2021
Why is LIBOR going away: The ubiquitously used global benchmark's flaws became known during the Global Financial Crisis ("GFC") when the rate was being manipulated. This catalyzed a global effort to reform the rate and the eventual decision for LIBOR to be phased out by regulators. LIBOR is linked to $200+ trillion of financial contracts. Since banks no longer fund themselves through interbank wholesale lending (~$500mm transactions per year) post GFC, the rate is heavily determined by the expert judgment of relatively few parties i.e., the panel banks.
What happens with less than 2 months left before LIBOR cessation? We break down the facts & mechanics of the end of LIBOR
Rewind the Clock: Benchmark Transition Event
On March 5, 2021, the U.K. Financial Conduct Authority and ICE Benchmark Administration, the regulator and administrator of LIBOR respectively, definitively announced that LIBOR will cease or no longer be representative on December 31, 2021 for all tenors in GBP, EUR, CHF, and JPY LIBOR in addition to 1W and 2M USD LIBOR.
Spread Adjustment for Legacy LIBOR Facilities
As a result of LIBOR being referenced in ~$200+ trillion of financial contracts, and the notional majority being tied to OTC derivatives, the ARRC adopted ISDA’s spread adjustment methodology for cash products to be implemented into hardwired fallbacks for existing facilities that will convert to SOFR upon LIBOR cessation. These spreads adjustments bear no reflection on current market conditions for new transactions.
New SOFR Facilities
New transactions, repricings, and/or refinancings should follow a conventional two-part pricing structure of SOFR + applicable margin. We believe the structure of pricing new risk should not change, rather reflect the representative risk through the margin or floor.
How sensitive is LIBORs Credit Component?
With new SOFR issuances in the term loan B market there has been much debate on whether a CSA should be applied as a standalone third component to price. In our view, risk should continue to be priced just as we have always priced it through the margin and/or floor. Many cite SOFR's lack of a credit component as the reason why a CSA is needed; however, what many market participants do not realize is that LIBOR has not been that sensitive for sometime, especially when the facility has a floor. The average LIBOR/SOFR spread for a loan with a 50bps floor over three years is 5.5bps. Additionally, LIBOR has been at historic lows for 20 months and yet no one has talked about that. As no new LIBOR ensues in the New Year, we find it hard to compare SOFR to historic LIBOR levels as a means to derive price.
Lean In Now
As we look forward, we, like the Fed, the ARRC, and regulators globally, believe now is the time to act. Leaning in now will help prepare the market and investors for a very active first half of 2022.
- SOFR Starter Kit: Includes background, facts and figures about SOFR, and next steps market participants can take.
- SOFR Term Rates Factsheet: A summary of the rationale behind the ARRC's formal recommendation of forward-looking SOFR Term Rates.
- A User's Guide to SOFR: An overview of the considerations market participants interested in using SOFR should evaluate.
Lining Up the Last Days of LIBOR, the latest in the "Solving the Puzzle of LIBOR Reform" series co-authored by Lara Rhame, Chief U.S. Economist at FS Investments, and Tal Reback, Principal at KKR.
Note: Unless indicated, the above reflects the current market views, opinions and expectations of KKR based on its historic experience and other analysis. Historic market trends are not reliable indicators of actual future market behavior or future performance which may differ materially, and are not to be relied upon as such.