As the end of LIBOR draws near, the FCA, the Bank of England and the Working Group on Sterling Risk-Free Reference Rates (the working group) are encouraging market participants to actively move from referring to LIBOR rates in their loan agreements to risk-free rates (such as SONIA). An important aspect that market participants need to consider in this context is credit spread adjustment (CAS) that are 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 risk-free rates caused by the lack of a credit risk premium in risk-free rates.
Whilst the Working Group has recommended a CAS approach applicable in replacement or replacement screen provisions, it did not cover CAS in active transitions prior to a cessation or loss of representativeness (default) event in relation to GBP LIBOR. With this in mind, the working group published a paper on 17 December 2020 outlining the potential CAS methodologies for use in actively converting GBP LIBOR-related loans to SONIA (the CAS paper).
The CAS paper provides descriptions, possible considerations and working examples of two possible methods for CAS: the five-year historical median approach (similar to ISDA) and the forward approach. It provides lenders, borrowers and investors who are actively changing their documentation to reference SONIA rather than relying on the appropriate fallback provisions relating to SONIA. As market participants transition to multi-currency lending, they will need to reconsider their approach to all non-sterling tranches.
Five-year historical median approach
This approach looks at the historical differences between GBP LIBOR and the SONIA arrears rate over a five year period. The CAS is based on the difference between GBP LIBOR and SONIA over a given interest period, calculated using a median over a five year look back period. The five-year historical median approach was adopted by the ISDA in its 2006 ISDA Definitions Supplement (for more information, see here) and has previously been used in a number of lending transactions that included an integrated switch to risk-free interest rates.
The CAS calculation is based on the forward looking basis swap transaction market used to calculate the implied future difference between GBP LIBOR and SONIA. It is calculated as a linear interpolation between different maturities of GBP LIBOR vs. SONIA swaps. This method was also used in some lending transactions.
Market participants are free to choose which CAS methodology to use when actively transitioning to SONIA. In determining which spread adjustment method to use, the working group identified a number of important considerations that should be taken into account.
- Associated hedging: Market participants should carefully consider how related hedging instruments have been transitioned and strive to avoid any mismatch between a loan and its hedge.
- Timed coordination: The timing of calculating the CAS will be important. Market participants should consider whether the calculation occurs at the time of the transaction or (if later) at the time of switching to SONIA. The date is important as the market prices used in the CAS calculation are subject to change.
- Fair treatment of borrowers: The working group stresses the importance of treating borrowers fairly when choosing between CAS methods. Certain borrowers may be able to assess the fairness of conversion agreements while other, less experienced borrowers may not be able to. This should be taken into account by lenders.
- economic impact: Perhaps the most important consideration for the parties to a financial 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 therefore use of this approach may result in a CAS that does not reflect the difference between GBP LIBOR and SONIA on a given date and in the future. Indeed, this was evident in the early stages of the COVID-19 pandemic, when the spread calculated using a five-year historical median moved from well above the actual GBP LIBOR SONIA spread to well below it. In contrast, a CAS based on the forward approach reflects the expected difference between GBP LIBOR and SONIA for the remaining life of the loan. This therefore includes market opinions on the way to discontinue GBP LIBOR.
- Accordance with market precedents: Both methods have been used in some GBP loan market transactions. However, the historical five-year median approach has not been used in the bond or derivatives markets for active transition.
- transparency: Bloomberg currently publishes a five-year historical median CAS through licensed channels as well as on its own website (time-delayed). However, these releases are related to ISDA fallbacks and the terms and use of access to the Bloomberg CAS are yet to be confirmed in relation to the sterling lending market. Regarding the forward approach, the GBP LIBOR – SONIA base screens are available through a number of suppliers. Market participants should consider the level of transparency afforded to them by each of these methods and the ease with which the borrower and the lender can access the CAS calculated according to each of them.
- Term(s) of the existing GBP LIBOR: If the loan has multiple tenors to choose from, the borrower and lender should agree on which GBP LIBOR tenor(s) (e.g. 1, 3, 6 months) to use for the calculation of the CAS. The CAS differs depending on the tenor used.
- Stability of a long-term median: Using a long look-back period rather than a single observation makes the five-year historical median less prone to market distortions over short time periods.
- Operational Considerations: Lenders should continually assess the operational considerations for managing and maintaining the CAS across a broad portfolio of transactions. The forward approach requires a tailored solution as it contains inputs dependent on the loan’s profile. Using a five-year historical median approach could simplify the operational process of calculating the CAS.
The US Alternative Reference Rates Committee has proposed an “early opt-in” CAS which, if the parties elect to trigger it, will be subject to an indicative CAS with respect to the SOFR targets. termination event. This means that parties are free to deviate from LIBOR prior to a termination or default event and then set the CAS on a termination or default event and adjust it to any of their exposures 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 encourages credit market participants to actively transition and the CAS paper is a useful guide to the key considerations in determining the most appropriate approach to applying a CAS to their transitioned loans.