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More than a trillion dollars of risky US corporate loans are still tethered to Libor just four months before the tainted lending rate expires, with borrowers and investors scrapping over the fine print as the deadline approaches.
Industry participants estimate only about 25 per cent of the $1.4tn US “junk” loan market has switched to Libor’s replacement, known as the Secured Overnight Financing Rate, ahead of the June 30 deadline. The rest is caught in a tug of war between the highly-indebted companies that issued the Libor-tracking debt and the investors that bought it, over the rate that different loans will pay in future.
With time ticking, the terms of some loans would mean a shift to more punitive rates if a solution cannot be agreed. Others would revert to the lower Sofr rate, but with an adjustment to stop investors being left out of pocket. Borrowers and lenders have been left to wrangle over how large this extra “spread” should be, loan by loan.
“The Libor to Sofr transition has gotten really contentious,” said Roberta Goss at $51bn investment management firm Pretium Partners.
Ending daily publication of the US dollar version of Libor is the last and biggest obstacle in a transition away from the benchmark, which for decades was used to price various debt and derivative instruments around the world and was at the heart of a series of manipulation scandals following the global financial crisis.
Leveraged loans, which are usually sold by low-rated companies with high levels of debt, are a crucial battleground partly because of the speed with which they have proliferated over the past decade as companies and private-equity backers took advantage of the cheap money era to fuel a dealmaking frenzy. In 2021, US issuance totalled $615bn, up from $289bn a year earlier, according to data from LCD, a data provider.
The floating interest rates on these loans means their payouts to investors have soared in the past year as the Federal Reserve lifted interest rates from near-zero to more than 4 per cent. Issuers must now shift their loans over to Sofr while attempting to keep rising funding costs as manageable as possible.
While new loans sold since the end of 2021 have referenced Sofr rather than Libor, a drop-off in issuance as interest rates climbed last year has left the bulk of the market yet to be refinanced at rates linked to the new benchmark.
Holders of collateralised loan obligations — vehicles backed by bundles of loans that have hoovered up about two-thirds of the leveraged loan market — are pushing for more favourable terms. They are demanding an additional “credit spread adjustment” in updated Libor-based contracts to compensate for the lower Sofr rate. But many corporate borrowers and their private equity backers want smaller spread adjustments to keep down their interest costs.
The current Sofr rate is 4.55 per cent. Rates for Libor vary depending on the length of the term but all are higher than Sofr and the most widely used rate, three-month Libor, is 4.95 per cent.
Demand from CLOs is essential for many companies to access fresh debt financing, giving their managers enormous clout in the renegotiation process. “Where CLOs go, the loan market goes,” said Goss.
The official panel overseeing the Libor transition in the US has set out a series of recommendations for loans switching over to Sofr, including how large spread adjustments should be. But borrowers and lenders are under no obligation to follow the guidelines, causing friction between the two sides.
“There have been different opinions as to what the [adjustment in the rate] should or shouldn’t be for loans that are transitioning from Libor to Sofr,” said Adrienne Butler, head of US CLO funds at Barings.
Some companies have sought a 0.1 percentage point uplift in Sofr, much less than the 0.26 percentage points recommended for three-month Libor by the panel. Most of these deals have been “getting pushed back” by lenders, according to John Gregory, head of the leveraged finance syndicate at Wells Fargo.
Despite the volume of Libor-linked loans still outstanding, market participants said the pace of amendments was accelerating. Butler was confident that ultimately, the switchover “will get done”.
But the scale of the remaining task means that a last-minute scramble by companies, investors and their lawyers to strike a deal is likely before the deadline.
“Some people have adopted a wait-and-see view,” said Patrick Ryan, head of the global banking and credit practice at law firm Simpson Thacher. “[But] if we were having this conversation in May and you were telling me we were still waiting for 75 per cent of loans to transition, then I would say a lot of people have a lot of work to do.”
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