Analysis-Clock Ticking For Loan Market As Libor Nears Its End

It’s crunch time for the corporate loan market.

With under five months until the June 30 end-date for the publication of the London Interbank Offered Rate, around 80% of institutional loans and collateralized debt obligations (CLOs) – securities backed by pools of debt – are still tied to the tarnished rate, according to private equity firm KKR & Co Inc, which is a lender, a borrower, and an investor in CLOs.

“The shot clock is on,” said Tal Reback, who leads KKR’s global Libor transition efforts.

The Libor transition began in 2017 and had been smooth until 2022, when rising interest rates, decades-high inflation, Russia’s war on Ukraine and recessionary fears rocked markets.

With opportunistic deals shelved, many issuers were prevented from tapping the markets, which is when they would normally revisit existing debt and potentially convert it to another rate, slowing the transition.

“The new issue market shut down,” said Ian Walker, head of legal innovation at financial information provider Covenant Review. “They were under so much volatility and uncertainty that we didn’t really see any remediation effort last year.”

There has been an uptick in loans switching to the Federal Reserve’s recommended Secured Overnight Financing Rate (Sofr) from Libor so far this year, but “a huge volume” still needs to transition, he said.

Of the loans, many of which are held by CLOs, that still need to remediate, about 55% risk falling back to the prime rate, which is 7.75%, compared to around 4.5% for Sofr, if they do not find a transition path before the deadline, according to KKR.

That difference could hurt borrowers with lots of debt and lower credit ratings, like CCC or B-, as their chances of downgrades rise, and it also puts lenders, such as CLOs that are measured by how many CCCs and defaults are in their vehicles, in a difficult spot, said Reback.

“That is a significant risk for the loan market,” she said.

Quibbling over the size of spread adjustments to compensate for the difference between Libor and Sofr has been a sticking point in some cases, as borrowers feel the pain of rising rates and lenders use the transition as a bargaining chip to get a few extra basis points.

“You have to prioritize long-term market and credit health and time is of the essence,” said Reback.

TERM PAPER BLUES

Once dubbed the world’s most important number, Libor – a rate based on quotes from big banks on how much it would cost to borrow short-term funds from one another – has been used to price hundreds of trillions of dollars of financial products, from mortgages and student loans, to derivatives and credit cards.

Regulators mandated Libor’s end after fining banks billions for rigging the rate, and have recommended the use of alternatives compiled by central banks, like Sofr.

Libor was phased out for new contracts at the end of 2021, though most existing U.S. dollar-denominated contracts have until June 30 to switch.

To ease the process for “tough legacy” contracts, which do not have provisions for replacing Libor, Congress in March 2022 enacted the Libor Act, allowing these contracts to automatically switch to Sofr, plus a 26 basis point spread in most cases, after June 30.

But many contracts have language in them, unrelated to Libor ending, that includes a fallback to prime, and those fall outside of the scope of the Libor Act, said Alston & Bird partner George Cahill.

“There’s a risk that for a borrower who isn’t able to amend its documents before Libor goes away, the rate will be based on prime instead of Sofr, which is significantly higher,” he said.

To help ease that burden, Britain’s Financial Conduct Authority, which oversees Libor’s administrator, is considering allowing a “synthetic” version of Libor for some U.S. dollar denominated maturities until the end of September 2024.

But that rate could be higher than the rate issuers would get if they transitioned to a new rate before June 30, said Meredith Coffey, executive vice president of the Loan Syndications and Trading Association.

Some contracts also have fallback language that says they must automatically switch to a new rate when Libor ceases to exist or becomes “non-representative,” which a synthetic Libor would be, so people should not wait, said Coffey, likening the process to writing a term paper until the night before it’s due.

“You might be fine. But you might get a C-, so why would you do that?” she said.