By TAL REBACK Jan 18, 2023
Why Market Participants Should Act Now
“The struggle itself is enough to fill a man’s heart.”
–Albert Camus, The Myth of Sisyphus
A little more than a year ago, market participants were preparing for the penultimate step to LIBOR’s demise as the deadline for no new LIBOR origination approached on January 1, 2022. In anticipation of this goal, industry, regulatory, and market leaders worked for over a decade to solve the problem of how to thoughtfully unwind over $300 trillion of LIBOR-linked contracts and instruments.
As the clock struck midnight and we ushered in 2022, the eternal optimists of the LIBOR transition looked ahead to new SOFR issuance and market-making; digesting the rate change in capital structures and embarking on the Herculean task of converting legacy LIBOR loans to the new benchmark ahead of a seemingly distant deadline: June 30, 2023.
Suffice it to say, the market tumult of 2022, a hawkish U.S. Federal Reserve, and global macroeconomic headwinds put a wrinkle into this plan. Rising rates took center stage in 2022 and will remain in focus until the Fed believes inflation is under control, the labor market has cooled and the U.S. Dollar (USD) weakens. At this time, we believe that the Fed will continue to stay the course and anticipate that the fed funds rate will peak at 5.125% this year, which should be considered when making transition and hedging plans for SOFR.
As of December 31, 2022, only about 21% of the syndicated loan market had transitioned to SOFR, including: 36% of credits trading at par or better with a weighted average rating of BB- and 22% of credits trading between $95–$100 at a weighted average rating of B+. Lower-rated loans have been lagging behind. As 56.8% of the Morningstar LSTA U.S. Leveraged Loan Index is rated single-B and below, the balance of work left lies across loans trading at a discount with higher leverage. This backup in loans also contributes to the delay in CLOs being able to transition, as most CLO vintages are triggered to flip to SOFR once 50% or more of the underlying collateral has transitioned.
LIBOR Spreads and Volatility Increased Dramatically in 2022
The message is clear: We are well behind where we should have been with less than six months left. The consequences of not acting now could be significant for both borrowers and lenders, including:
- Exacerbated LIBOR widening due to illiquidity in LIBOR-linked instruments, which may in turn contribute to stress in asset liability management;
- An operational traffic jam at agent banks effectuating amendments; and
- The potential use of synthetic LIBOR if loans do not transition by June 30, 2023.
Credit Rating and Trading Levels Directly Correlated to SOFR Progress
It is incumbent upon market participants across both sides of the balance sheet to lean in and proactively transition away from LIBOR. As we noted previously, it is time to let go of the past and move forward. Here are the key risks that we see ahead:
Liquidity is the Achilles’ heel of the market and is often overlooked when markets are calm, but it is the key to agility and downside protection during volatile times. LIBOR-linked products today are already significantly less liquid than they were in December 2021, and they will continue to become more illiquid, ultimately contributing to widening spreads. Given that banks are no longer making markets in LIBOR, LIBOR quotes are predominantly set by the panel banks and have not been a reflection of credit risk in the market for some time. The scarcity of actual transaction data creates a risk for broader market participants, as it does not provide true pricing depth and increases the probability that LIBOR spreads will widen significantly due to technical factors.
Credit Rating and Trading Levels Directly Correlated to SOFR Progress
An Amendment Jam
The vast recalibration of risk assets in 2022 and stalled capital markets activity slowed the LIBOR transition (Exhibit 4). Due to the environment, the pace and ability to execute loan amendments declined dramatically as well as suppressed activity to opportunistically refinance to SOFR. Had the market been able to continue to effectuate amendments at a linear pace throughout the second half of 2022, we estimate that over 50% of the loan market could have already transitioned to SOFR (Exhibit 5).
Although many credit agreements contain fallback language to ensure there is a mechanism in place to transition to SOFR on July 1, 2023, we believe that should be treated as legal belt and suspenders in the event that there is no opportunity to transition ahead of the deadline. It is important to budget enough administrative and operational time ahead of the deadline to execute these amendments. Many credit agreements call for 5 business day negative consent process to pass the SOFR amendment, and agent banks could face a potential operational traffic jam should market participants not thoughtfully sequence the balance over the coming months.
Anemic 2022 New Issue Volumes and Market Volatility Impacted Transition Progress
If SOFR Transition Had Stayed on Track, it Would Be More than Halfway Done
Cost of Capital and Credit (or Conversion) Spread Adjustment (the CSA)
Borrowers have had to digest the rapid increase of their cost of capital in a short period of time and lenders have been on the receiving end of rising rates; however, it is incumbent upon both parties to engage in a dialogue to transition to SOFR given the illiquidity risk in LIBOR, the operational risks to procrastinating, and the overall credit health of the debt. Even in the current higher-rate environment, transitioning now can act as a mini-hedge against future volatility.
As a reminder, the Alternative Reference Rates Committee (ARRC) adopted the International Swaps and Derivatives Association’s (ISDA) spread adjustment methodology for cash products to be implemented into hardwired fallbacks for existing facilities that will convert to SOFR upon LIBOR cessation. These spread adjustments do not currently reflect market conditions for new transactions. Although many market participants cite the forward curve to derive a CSA, we see this as a circular approach. The LIBOR and SOFR forward curves are calculated using derivative transactions and have already priced in the ISDA spread adjustments (1M 11.4bps, 3M 26.2bps, 6M 42.8bps). Plus, the LIBOR curve is going away, and illiquidity risk skews the picture it paints. As such, the forward curve does not hold much comparative value.
The LIBOR Forward Curve Is Becoming Obsolete
LIBOR Legislation and Beware Synthetic LIBOR
The passage of the Adjustable Interest Rate (LIBOR) Act was a tremendous step to create a framework for replacing LIBOR in certain contracts that do not clearly define a replacement benchmark rate. In December, the Federal Reserve Board adopted the final rule that implements the LIBOR Act by identifying benchmark rates based on SOFR that will replace LIBOR for certain contracts governed by U.S. law. The UK Financial Conduct Authority (FCA) is considering the use of a non-representative, synthetic USD 1M, 3M and 6M LIBOR from July 1, 2023 to September 30, 2024 for use in certain legacy LIBOR contracts.
Synthetic USD LIBOR is essentially dressed-up SOFR, plus the respective ISDA fixed CSA per tenor. Whether synthetic USD LIBOR will apply to contracts governed by U.S. law depends on what the individual contract says, including how LIBOR is defined and/or whether there is a non-representativeness trigger. Where synthetic USD LIBOR does not apply and a contract is not transitioning pursuant to the LIBOR Act, there is a risk that an unremediated contract could go to Adjusted Base Rate (ABR) which is typically defined as the Prime rate, 7.5%. Relying on synthetic LIBOR would add unnecessary complexity to an already complex, multi-year transition process. Procrastination or potential reliance on levers such as the use of synthetic USD LIBOR gives rise to litigation risk due to differing interpretations of contracts, prolonged remediation, and potential economic implications. Moreover, it kicks the metaphorical LIBOR can down the road for no good reason.
No Room for Sisyphus
We often to look to Greek mythology for wisdom and find it very relevant here. In many ways, this transition has felt like a Sisyphean task and many of us have spent years, if not more than a decade, solving for the ever-evolving challenges it has presented. Unlike Sisyphus, however, we are not condemned to keep pushing this boulder up a hill for eternity. As prudent students of history, we believe in learning from the past and leaning in where we believe we can help drive a beneficial outcome. We are now nearly at the top of the mountain and on the precipice of the big push. Don’t let procrastination or inertia push this LIBOR boulder back down.
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