I hope it is already clear that the discontinuation of LIBOR should not be considered a remote probability ‘black swan event’. Firms should treat it as something that will happen and which they must be prepared for. Andrew Bailey, Former Chief Executive, Financial Conduct Authority, 2018
In 2017, the Financial Conduct Authority announced that it would cease to compel or persuade banks to contribute to LIBOR submitting panels as from the end of 2021. This decision was widely expected to lead to the cessation of the benchmark on or shortly following that date. Notwithstanding ongoing consultations regarding a possible extension to the date of cessation of US dollar LIBOR for overnight, 1, 3, 6 and 12 month tenors to 30 June 2023, regulators have re-emphasized the need for new transactions to no longer reference LIBOR as a benchmark and to make preparations for legacy LIBOR referencing deals to transition to new benchmarks. Any such extension is only be intended to reduce the amount of legacy LIBOR deals needing to transition and is not intended to promote the continued use of LIBOR in new transactions beyond 2021. So what is the current status of transition from LIBOR in the loan market and how is this likely to affect the aviation industry?
Secured Overnight Financing Rate (SOFR)
Regulators have recommended that market participants use so-called risk-free rates instead of LIBOR and a risk-free rate has been identified for each currency for which LIBOR is currently published. As aircraft are a US dollar asset, the most important risk-free rate for the aviation industry is therefore SOFR which is the risk-free rate identified for US dollars. This is a relatively new rate, first published in April 2018, which measures the broad cost of borrowing US dollars, overnight collateralized by US government securities. It is published at 8 a.m. Eastern Time on each New York banking day by reference to the interest charged on the previous day and is administered by the Federal Reserve Bank of New York.
Challenges for the loan market
Because of the differences between risk-free rates and LIBOR, their use presents a number of challenges for loan documentation. First, because they are backwards looking daily rates, the borrower will only know towards the end of the interest period what the interest payment is going to be. Secondly, use of risk-free rates involves a complicated calculation, which can be difficult to verify. Thirdly, over the same period, risk-free rates will be lower than LIBOR as they do not incorporate term and bank credit risk. This gives rise to a risk of “value transfer” i.e. the idea that one party may benefit and one party may lose on a transition of legacy LIBOR referencing transactions to risk-free rates. Finally, for inter-linked LIBOR referencing financial products such as loan agreements and related hedging agreements, there is a danger that basis risk (i.e. the risk of the hedge proving to be ineffective) could emerge if transition to risk-free rates does not occur at the same time and on the same basis. In recent months, regulators, industry bodies and market participants have sought ways to tackle these issues.
Budgeting: The use of a “look back”
To address budgeting, it is now generally accepted that the rate will be calculated by using a look back, which is an agreed number of banking days prior to the date on which the rate of interest is to be determined. The screen rate used to determine the rate on any given day in the interest period will therefore be the screen rate published the relevant look back prior to that day. In this way, borrowers will have the relevant look back number of days’ notice of the total interest payment due. For example, for an interest period running from January 1 to June 30, with a look back of five days (and ignoring the incidence of non-banking days for present purposes), the interest would be calculated based on screen rates between December 26 and June 25, and payable on June 30.
Differences in calculation methodology
However, differences have emerged in terms of the method of calculation of the rate. Originally the most favored approach to rate calculation appeared to be the cumulative compounded rate which calculated over an observation period commencing the look back (let’s say five banking days) prior to the commencement of the interest period, and ending five banking days prior to the interest payment date at the end of the interest period. However, when using this method, it is not possible to determine accurately interest prior to the end of the observation period and this causes problems in establishing the interest to be payable on a mid-period pre-payment and for the purposes of secondary loan trading. As such, the London market now favors the calculation of interest by reference to the daily non-cumulative compounded rate. The daily non-cumulative compounded rate is derived from the cumulative compounded rate using a three-step complex calculation and was recommended by the Sterling Reference Rates Committee of the Bank of England in their recommended market conventions for SONIA (the risk-free rate for Sterling). The Loan Market Association (LMA) applied these conventions to SOFR and US dollar loans in their recently published switch clause exposure draft precedent.
The Alternative Reference Rates Committee of the Federal Reserve Bank of New York (ARRC), whilst also recognising the need for interest to accumulate daily to enable the accurate calculation of interest mid-period, recommends the use of a simple uncompounded daily rate as an alternative to a compounded rate. Although the ARRC acknowledged that a compounded rate is a better reflection of the time/value of money, it does not view there being sufficient basis difference between the compounded and uncompounded rates to justify the additional complexity of the former.
Mitigating the risk of value transfer: The ISDA historical median approach
To mitigate the risk of value transfer on a transition of legacy LIBOR referencing transactions to risk-free rates, it is generally accepted that a spread adjustment will need to be made. The favored method for calculating the spread adjustment is the ISDA historical median approach. The historical median approach involves comparing the relevant LIBOR and compounded risk free rate for an equivalent tenor over a significant static look back period of five years prior to the date of transition. The median spread between LIBOR and the compounded risk-free rate would then be applied as the credit adjustment spread for the relevant transaction. On every banking day in the US, Bloomberg will publish the spread adjustment to be used in the fallback language for ISDA standard documentation. They will start to do this on an indicative basis before the spread adjustment is eventually fixed. In this way, parties will be able to see the relevant credit adjustment spread on a screen.
ISDA have recently said that if ICE Benchmark Administration Limited as administrator to LIBOR announces the dates on which LIBOR will cease to be published following current consultations then that will constitute an “Index Cessation Event” for the purposes of ISDA documentation and will trigger the fixing of the credit adjustment spread by Bloomberg. As such, it may well be the case that the credit adjustment spread for the purposes of ISDA documentation is fixed ahead of the actual cessation of the publication of LIBOR.
In the loan market there have been questions as to the suitability of the historical median approach to determine the credit adjustment spread in legacy LIBOR transactions that transition to risk-free rates ahead of actual LIBOR cessation. This is because the historical median approach measures a value at a single point in time based on a historical average and therefore does not necessarily represent present value on a forward-looking basis.
Some transactions which have already transitioned to risk free rates ahead of LIBOR cessation or which have incorporated switch provisions contemplating such a transition have instead determined the credit adjustment spread by reference to the forward market or simply agreed a rate. It will be interesting to see whether the loan market adopts the ISDA methodology for determining the credit adjustment spread going forward although in hedged transactions there will be a need for a consistent approach to be taken across hedging and loan documentation.
Challenges for the US dollar loan markets
However the rate is calculated, the use of risk-free rates will always involve a more complex calculation and more potential variables than the use of LIBOR. It is also clear that LIBOR cessation will lead to a divergence in approach between currency jurisdictions, regulators and different sectors of the market. This is particularly the case with respect to US dollar denominated transactions given the widespread use of the dollar throughout the world and is one of the reasons why the Asia Pacific Loan Market Association is planning to publish two versions of its precedents for US dollar loan transactions; one reflecting the approach taken in the US and the other reflecting the London market approach.
Interlinking financial products
The aviation finance industry will need to be particularly aware of these different approaches given the global nature of the industry and the fact that the aviation finance transactions are often highly structured. In any transaction where there are related LIBOR referencing financial products (such as a hedging agreement or a limited recourse loan and lease structure) then so far as possible, those products should transition to risk-free rates at the same time and on the same basis.
With respect to interest rate hedging, ISDA has recently published an IBOR Fallbacks Supplement which amends the floating rate options referencing IBORs in the 2006 ISDA Definitions. The ISDA Fallbacks Supplement will come into effect on January 25, 2021. The amendments set out in the ISDA Fallbacks Supplement will apply to transactions incorporating the 2006 ISDA Definitions entered into after January 25, 2021 unless the parties specifically agree to exclude them. The amendments provide that upon the occurrence of certain trigger events (such as IBOR cessation or a declaration by the regulator of the administrator of the IBOR benchmark that it is unrepresentative of the market it is intended to measure), references to IBOR floating rate options will transition to new fallback rates calculated using risk-free rates as a benchmark.
In addition, ISDA have published a Protocol to incorporate the amendments to the 2006 ISDA Definitions in legacy transactions entered into prior to January 25, 2021. If parties opt to enter into the Protocol then the amendments will apply to all legacy LIBOR referencing derivative contracts entered into between the parties to the Protocol unless those contracts are expressly excluded.
It is important to note that there are some differences between the market conventions recommended for SONIA and SOFR referencing loan agreements and those which have been applied in calculating the fallback floating rates in the IBOR Fallbacks Supplement and Protocol. For example, the ISDA fallback rate is calculated using a two-day look back and an observation shift. This is inconsistent with the equivalent Bank of England Sterling Reference Rates Committee recommended market conventions for the calculation of SONIA (which as noted previously have also been applied to SOFR in the London market). In addition, there may also be different trigger events to LIBOR transition contained in the loan agreement and corresponding hedging agreements, particularly in older contracts. LIBOR transition with respect to hedged transactions will therefore need to be carefully managed and documented.
What to do now?
As from the end of the first quarter of 2021, the Bank of England has recommended that lenders should no longer offer LIBOR referencing loan products that would extend beyond 2021. This recommendation has not changed following the consultation as to a possible extension to the date on which US LIBOR will cease to be published for overnight, 1 month, 3 month, 6 month and 12 month tenors. Other regulators have taken a similar approach. As such, it is anticipated that new loans will start to be documented using risk free rates from the outset.
It is therefore important that all market participants familiarize themselves with risk-free rates, how they are calculated and the terminology involved, bearing in mind that there may not be a consistent approach across all areas of the market.
Borrowers and lenders alike should audit their portfolios of LIBOR referencing documentation that extend beyond 2021 and for transactions referencing the US dollar LIBOR tenors referred to above, 30 June 2023 (assuming that following the consultation the cessation date for those tenors is extended). Interlinking financial products that need to transition at the same time and on the same basis should be identified. References to LIBOR will not only be found in loan documentation, for example LIBOR is frequently used in the formula for calculating floating rate rentals in operating leases and in default rate provisions.
Market participants should establish whether any consents or approvals would be required to a change in benchmark and any required time periods for this. This should include consideration of any required regulatory consents: for example, borrowers based in exchange controlled jurisdictions should check whether an amendment to a benchmark would require any state bank filing to be made or consent to be obtained.
It is also important to determine whether the documentation contains any express provision for a fallback rate to be used following LIBOR cessation and what the consequences of this would be. For example, most LMA based documentation would revert to the cost of funds of individual syndicate lenders if LIBOR were to cease and there was no agreement to transition to risk-free rates.
For new transactions, parties need to consider whether LIBOR should still be used as a benchmark at all. Would it be possible to use risk-free rates as a benchmark from the outset or, if not, would it be possible to include a more robust set of fallbacks or a timetable for transition to risk-free rates? In particular, the use of LIBOR should be avoided in clauses such as operating lease default rate provisions where there is no connection to any underlying financing.
LIBOR transition would present a challenge for the industry at any time, however in the current climate it may seem particularly difficult to manage. Proper planning and preparation now can help to mitigate any subsequent problems resulting from transition to risk-free rates.
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