With the end of LIBOR drawing closer, the FCA, Bank of England and the Working Group on Sterling Risk-Free Reference Rates (the Working Group) are encouraging market participants to actively transition from referencing LIBOR rates in their loan agreements to risk-free rates (such as SONIA). In this respect, one important aspect that market participants need to consider is the credit spread adjustment (CAS) that will be required. Market participants use a CAS to mitigate the risk of value transfer when transitioning to risk-free rates due to the difference between LIBOR rates and the risk-free rates, caused by the lack of a credit risk premium in risk-free rates.
While the Working Group has recommended an approach to CAS applicable in fallback or replacement screen provisions, it did not cover CAS in active transitions in advance of a cessation or loss of representativeness (pre-cessation) event in relation to GBP LIBOR. In light of this, the Working Group published a paper on 17 December 2020 discussing the potential CAS methodologies for use in the active transition of GBP LIBOR-referencing loans to SONIA (the CAS Paper).
The CAS Paper sets out descriptions, potential considerations and worked examples for two potential methodologies for CAS: the five-year historical median approach (similar to ISDA) and the forward approach. It provides guidance to lenders, borrowers and investors who are actively amending their documentation to reference SONIA, rather than relying on the relevant fallback provisions with respect to SONIA. Where market participants are transitioning multicurrency loans, they will need to consider their approach in respect of any non-sterling tranche.
Five-year historical median approach
This approach looks at the historical differences between GBP LIBOR and the SONIA compounded in arrears rate over a five-year period. The CAS is based on the difference between GBP LIBOR and SONIA over a particular interest period, calculated using a median over a five-year lookback period. The five-year historical median approach has been adopted by ISDA in its 2006 ISDA Definitions Supplement (more information on which can be found here) and has been used in a number of loan deals to date that have included a built-in switch to risk-free rates.
The CAS calculation is based on the forward-looking basis swap transactions market, which is used to calculate the implied future difference between GBP LIBOR and SONIA. It is calculated as the linear interpolation between differing tenors of GBP LIBOR vs SONIA swaps. This methodology has also been used in some loan deals.
Market participants are free to choose which CAS methodology to apply when actively transitioning to SONIA. When determining which spread adjustment methodology to use, the Working Group has identified a number of key considerations that should be borne in mind.
- Associated hedging: Market participants should carefully consider how associated hedging instruments have been transitioned, and endeavour to avoid any mismatch arising between a loan and its hedge.
- Timing: The timing of calculation of the CAS will be important. Market participants should consider whether the calculation will be made at the date of the transaction or (if later), at the point of the switch to SONIA. The date is important as market prices that are used in the CAS calculation may move.
- Fair treatment of borrowers: The Working Group stresses the importance of the fair treatment of borrowers in the choice between the CAS methodologies. Certain borrowers may be able to assess the fairness of conversion arrangements while other, less sophisticated borrowers, may not. This should be considered by lenders.
- Economic impact: Perhaps the most important consideration for parties to a finance transaction is the economic impact of the chosen methodology. The historical median approach does not necessarily represent the actual difference between GBP LIBOR and SONIA, and so using this approach may give a CAS that is not reflective of the difference between GBP LIBOR and SONIA on a particular date and in the future. Indeed, this was evident in the initial stages of the COVID-19 pandemic, as the spread calculated using a five-year historical median moved from substantially above to well below the actual GBP LIBOR – SONIA spread. In contrast, a CAS based on the forward approach will reflect the expected difference between GBP LIBOR and SONIA for the remaining duration of the loan. This therefore incorporates market views on the path of GBP LIBOR cessation.
- Consistency with market precedent: Both methodologies have been used in some GBP loan market transactions. However, the five-year historical median approach has not been used in the bond or derivatives markets for active transition.
- Transparency: Bloomberg currently publish a five-year historical median CAS through licenced channels, as well as on their own website (on a delayed basis). However, these publications are in the context of ISDA fallbacks, and the terms and use of access to the Bloomberg CAS is yet to be confirmed with respect to the sterling loan market. As to the forward approach, the GBP LIBOR – SONIA basis screens are available through a number of vendors. Market participants should consider the level of transparency afforded to them under each of these methodologies, along with the ease with which the borrower and lender(s) are able to access the CAS calculated under each of them.
- Tenor(s) of existing GBP LIBOR: Where there are multiple choices of tenor under the loan, the borrower and lender(s) should agree which GBP LIBOR tenor(s) (e.g. 1, 3, 6 months) should be assumed for calculating the CAS. The CAS will be different depending on the tenor(s) used.
- Stability of a long-term median: The use of a long lookback period rather than a single observation makes the five-year historical median less susceptible to market distortions over short periods.
- Operational considerations: Lenders should assess the operational considerations of managing and maintaining the CAS on an ongoing basis across a wide portfolio of deals. The forward approach requires a bespoke solution as it will include inputs subject to the profile of the loan. Using a five-year historical median approach could simplify the operational process of calculation the CAS.
The US Alternative Reference Rates Committee has suggested an ‘early opt-in’ CAS, which, if the parties decide to trigger it, looks to an indicative CAS with respect to SOFR during the period until the CAS becomes fixed on a cessation or pre-cessation event. This means that parties will be free to transition away from LIBOR prior to a cessation or pre-cessation event, then have the CAS become fixed upon a cessation or pre-cessation event, aligning it with any of their loans for which they did not trigger the ‘early opt-in’. However, this approach has not yet been used in the sterling loan market.
The Working Group strongly encourage loan market participants to actively transition, and the CAS Paper is a useful guide to the key considerations in determining the most suitable approach to applying a CAS to their transitioned loans.
Please contact any of the authors of this briefing or your regular McGuireWoods contact if you have questions about, or would like assistance with, the LIBOR transition.