Commentary: Where the LIBOR transition stands – and why it’s OK

The economy today is subject to numerous sources of uncertainty, to say the least of the COVID-19 pandemic and its market impact. Among those sources of uncertainty is the yet unresolved transition toward a new agreed upon reference rate and away from LIBOR.

The transition from LIBOR in 2021 has been signaled, discussed and deliberated within the halls of financial institutions for years, having implications for lenders and borrowers alike. Still, as we now sit about a year from the transition date, there are still material items and processes to be determined. The world of syndicated loans, for example, must sort through the inventory of agreements that never had language prepared for such an event.

There is good reason to believe, though, that investors and market participants at large should not be worried. Banks of all sizes are preparing action groups and have their ears tuned to discovering a consensus alternative rate. And despite the ceaseless disruptions of 2020, the road to a new LIBOR appears to not be delayed nor off course, rather working through some (expected) bumps.

LIBOR grew popular in the 1970s, quickly becoming the single most important number in finance. Banks used it as a reference for pricing interbank lending, and many, if not all, currently outstanding syndicated loan agreements have incorporated it in the calculation of all-in rates.

Since its adoption, though, LIBOR has been subject to a handful of notable controversies, none more salient than the price fixing of 2012. Because LIBOR is calculated by aggregating the analysis of a panel of major banks, those participating in the panel were able to submit false data and manipulate prices. Whether or not these schemes proved effective or market moving, investors realized that they could not continue to leverage a metric with perverse incentives. Consequently, in 2014, the U.S. Federal Reserve and other national regulatory and central banking bodies announced the intention to move away from LIBOR.

In many respects, the end of LIBOR has already arrived for direct lenders. The direct lending industry has embraced the ability of one-to-one, private agreements to eschew marketwide standards such as LIBOR in crafting agreements. Conditions as valued by LIBOR are simply less material when two parties do their homework.

There's no need for investors in direct lending funds to worry. The market is relatively healthy from a LIBOR point of view, and is more guarded from volatility and inflation as a result of the detachment.

Syndicated lending, on the other hand, will need to navigate the transition more thoroughly. Where direct lending can vary in duration and benefit from flexible management, syndicated loans often involve several parties and rely on LIBOR for rate agreements.

Syndicated loans can have life spans of seven-plus years, meaning their documentation won't necessarily have fallbacks for calculating LIBOR replacements. These arrangements will need to get together as borrowers and lenders negotiate in good faith. Borrowers will want a stable all-in rate (like LIBOR), and lenders will have to work with this expectation.

Each individual loan will be its own project. There will be no rule of thumb benchmark and finding the correct reference rate could be costly in terms of man hours and legal fees. The costs, if anything, will be the primary source of disruption, regarding LIBOR in the next 12 months.

Thankfully, banks are already searching for solutions. They're creating working groups to address their inventories of client contracts and exploring options for simple amendment plans. Thus far, the secured overnight financing rate, a benchmark rate for U.S. dollar-denominated derivatives, has caught steam, but it will need to document a successful track record and enjoy more widespread support before it becomes the standard. Such will be the case for any new reference rate to emerge — banks will require clarity from the marketplace. This might take months, and it might cause disruption, but the steady and thoughtful pace of adoption to date is reason for calm.

Of course, there is more to the discussion than simple market consensus. Timing of the new reference rate, among other concerns, will have to be settled. And investors should ensure that the portfolios they are investing in have representation from the lender side in amending the credit agreement documentation. But the gears are turning, and we feel confident that the LIBOR transition presents no reason to pull back from business as usual.

Treabhor Mac Eochaidh is head of debt services at MUFG Investor Services, based in Dublin.This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.