US loan market begins shift away from tarnished Libor benchmark
Companies borrowing in the US loan market are finally shifting away from Libor, just months before the scandal-hit benchmark underpinning trillions of dollars of financial instruments will no longer be available for new deals.
A handful of companies have now borrowed cash using the widely accepted replacement for Libor called Sofr, according to data from Refinitiv and LCD. Others are in the market with new deals.
The adoption of Sofr — calculated based on market transactions — marks a significant step in establishing a new standard after Libor’s reputation was irrevocably damaged a decade ago when bankers were found to have manipulated the key interest rate. Regulators have mandated that no new deals should be tied to Libor starting from 2022, phasing out the benchmark by the end of June 2023.
“You can’t just keep writing Libor loans into December,” said Brian Grabenstein, head of the Libor transition office at Wells Fargo. “If we have to stop on December 31, it can’t just be business as usual until then.”
Libor has for many years acted as a baseline for which everything from mortgages, to credit cards and corporate loan interest rates are based, so the outcome of the benchmark reform process will have wide-ranging implications.
Bankers said the transition in the loan market has been slow, in part because there is no advantage for companies being the first to move away from Libor. Negotiations are still under way to determine new conventions for pricing deals tied to Sofr.
The slow adoption of a so-called term-Sofr rate, which allows companies to plan for upcoming interest rate payments by giving a forward-looking estimate of where Sofr will be, has also held back progress, bankers said. Nonetheless, there is a growing sense of urgency to accelerate adoption of Sofr before the hard stop at the end of the year.
Bank of America brought the first syndicated loan Sofr transaction in September for poultry producer Sanderson Farms, pricing the deal to Libor but with an automatic switch to Sofr at the end of the year.
JPMorgan, another big US bank, then brought the first deal priced to Sofr from the point of issuance in October, for commercial real estate finance company Walker & Dunlop.
Onex Credit Partners, which manages bundles of loans that back payments on new slices of debt called collateralised loan obligations, brought the first CLO deal tied to Sofr to market last week.
One area that has complicated the process is how to account for the fact that the Libor interest rate is higher than Sofr. That means that the interest rate on deals needs to be adjusted so the borrowing costs end up being even as deals are struck with the new benchmark.
The Alternative Reference Rates Committee, an industry body set up by the Federal Reserve, has recommended adjustments of roughly 0.11, 0.26 and 0.43 percentage points for one-month, three-month and six-month tenors, respectively.
However, some investors say companies and bankers are taking advantage of strong demand for new loans to lock in low adjustments.
This situation played out in the Walker & Dunlop deal when investors initially balked at a 0.1 per cent adjustment as being insufficient, according to people familiar with the matter. JPMorgan eventually struck an agreement to appease lenders.
“This is a very hot market,” said Steve Hasnain, a portfolio manager at PineBridge. “It’s a borrowers’ market. Lenders are not able to push back that much. I would argue that because of the market we are in, there is some value transfer taking place from lenders to borrowers.”
Nonetheless, bankers and investors expect the pace of adoption to continue to pick up before the end of the year. All new loan financings, such as for mergers and acquisitions that JPMorgan is underwriting are being tied to Sofr if they are expected to price next year, said Kevin Foley, the bank’s global head of capital markets.
Grabenstein added Wells Fargo has not “put a total stop on Libor loans, but we are going to the customer with Sofr first and only if there is a real need to use Libor should it still be considered.”
The ARRC last month warned market participants about leaving their transition away from Libor to the last minute. “You wouldn’t wait until the moving van arrives to pack up the china; you would carefully package and label everything beforehand,” said Tom Wipf, ARRC chair and vice-chair of institutional securities at Morgan Stanley.
Libor vs Sofr
Libor stands for the London Interbank Offered Rate and has been one of the most important interest rates in global finance since the 1970s. Originally designed as an estimate of unsecured bank funding costs to underpin bank-to-bank transactions, its usefulness dwindled as lenders increasingly began requiring collateral to trade with each other. Based on submissions by a panel of leading lenders, its reputation was tarnished when bankers were found to have been rigging the rate, leading to widespread calls for its replacement.
Sofr is the secured overnight financing rate, which differs from Libor because it is based on actual transactions in the repo-market, where cash is borrowed against assets such as Treasuries. The Alternative Reference Rates Committee, an industry body set up by the Federal Reserve, chose Sofr as its preferred replacement to Libor in 2017 but uptake across markets has been slow ahead of a year-end deadline to cease entering into new contracts pegged to Libor.