About half of the $1.4tn US junk loan market is still shackled to Libor just 30 days before the rate is set to expire, with meagre dealmaking activity curbing companies’ ability to split from the lending benchmark and embrace its replacement.
The slower-than-expected progress means that corporate borrowers and the institutions facilitating their switch to the new benchmark face a crunch point, as they strive to push loans over the line before the cut-off, to avoid automatically falling back on to potentially less favourable borrowing terms.
At least $700bn worth of lowly rated corporate loans are still priced using Libor, according to estimates from industry participants, despite years of warnings that the rate will cease this summer. Moody’s puts the percentage outstanding even higher, at approximately 60 per cent, or $900bn, as of May 19 — based on holdings within loan portfolios rated by the agency.
The rest of the market has migrated to the newly accepted benchmark in the US known as “Sofr”, the secured overnight financing rate, and the pace of transition has accelerated in recent months. But the clock is ticking for residual debt to catch up by June 30, with the flow hindered by economic and market strains.
“I expect everyone across the spectrum — banks, law firms, private equity companies and their portfolio companies — everyone will be impacted and busy doing what they can to transition their portfolio of deals by the end of the month,” said David Ridley, partner at law firm White & Case, pointing to “a lot of paperwork”.
Meanwhile, fresh borrowing in the low-grade loan market has been “quite anaemic” this year, according to Lotfi Karoui, chief credit strategist at Goldman Sachs.
“In an ideal world, you want a big chunk of the transition to happen via refinancing where you’re just replacing some of these old loans that reference Libor with new ones,” said Karoui. “In a more robust primary market environment, things would have happened organically.”
White & Case’s Ridley concurred that “the natural opportunity to transition via some larger transaction . . . effectively dried up during the course of last year”.
Ending the daily publication of the US dollar version of Libor is seen as the last hurdle in the shift away from the lending rate, which was used for decades to price various assets but was central to manipulation scandals following the 2008-09 financial crisis.
The transition to Sofr this year has been slowed by tensions between corporate borrowers and holders of their loans, most of whom are “collateralised loan obligations” — vehicles that scoop up loans, sort them into risk categories and sell the tranches on to investors.
Arguments have centred on the differences between the old and new lending benchmarks. Libor is deemed to include a built-in credit risk premium that Sofr lacks, prompting lenders to argue that loan amendment documents should offer Sofr plus some extra compensation.
However, companies are already facing much higher funding costs, because “leveraged loans” typically have floating rates — meaning their coupons have soared higher as the Federal Reserve has lifted interest rates. In turn, a number have pushed back against suggested “credit spread adjustments” that could increase payments following the Sofr switch.
But attention has shifted to getting things done rapidly. Many companies have fallback plans, but these are not necessarily attractive options.
According to analysis from research group Covenant Review based on the Credit Suisse leveraged loan index, more than two-thirds of loans linked to Libor have “hard-wired” language in their documents, meaning that come July 1 they will automatically revert to guidelines outlined by the Alternative Reference Rates Committee — a team of market participants convened by the New York Fed.
The ARRC suggests a range of “Sofr plus” adjustments to loan documentation for various lending timeframes. Hard-wired borrowers can fall back on to those terms, unless they try to rush through deals with smaller adjustments.
Other loans have different types of language to aid the switchover process. But a smaller cohort — 8 per cent of the Libor-linked market — has no succession language in their documents. That means they could revert to an even more costly “base rate” if they do not transition to Sofr in time.
For Tal Reback, a principal at private equity firm KKR who is on the ARRC board, “it’s not a panic moment because the market has proven to be very orderly — seeing the pace of amendments in April and May, there’s a lot”.
But the deeply-ingrained nature of Libor after such a long period of use still makes the transition challenging.
“Libor is like salt. It’s in everything — it’s very hard to take out once it’s in the cooking. But what you’re seeing is a whole new buffet,” she said.