Who Said the Rules of the Game Could Change Because LIBOR’s Going Away?
There’s been a lot of discussion in the fixed income world about the end of the London Interbank Offered Rate (LIBOR) and what might replace it. But what hasn’t been as widely discussed is an important consequence for investors in this space: changes to LIBOR language in new-issue and amended credit agreements—particularly how these changes are implemented. Mark Boyadjian, director of our Floating Rate Debt Group, and Reema Agarwal, vice president and director of research, explain.
For decades, lenders worldwide have used the London Interbank Offered Rate (LIBOR) to set interest rates for a variety of financial products, including interest rate swaps, student loans, mortgages, collateralized loan obligations (CLOs) and syndicated floating rate loans in which a group of lenders known as “the syndicate” work together to provide funds for a single borrower at a variable interest rate.
A panel of leading banks active in London set the LIBOR rate, which represents the level they have determined they can borrow short-term, unsecured funds in the interbank market. Put simply, LIBOR represents the average interest rate they (banks) would charge each other for a loan, and its widespread use by so many market participants was based on its construction and availability.
Hundreds of trillions of dollars’ worth of interest rate exposure is tied to LIBOR,1 which until recently was seen as a standard and accurate rate by a wide swath of market participants.
LIBOR has been beset with multiple pricing scandals over the past few years, casting doubt on the pricing process and its validity as a reference rate. The result is that LIBOR will eventually be discontinued. The Financial Conduct Authority has confirmed that the future sustainability of LIBOR can’t be guaranteed, but 20 of the LIBOR panel banks will continue to support it until 2021.
Why LIBOR’s Fate Matters to Us
It remains unclear what benchmark will replace LIBOR in the syndicated floating rate market. Notwithstanding the recent rise in LIBOR (roughly 100 basis points in the last six months) a change would require amendments to the contracts and credit agreements underlying trillions in global assets. The interest rates on many of these financial instruments are currently set based on LIBOR. If an alternative benchmark does not reflect the risk and return signatures provided by LIBOR, such a change will likely result in a resetting of the credit spreads syndicated lenders charge and borrowers are willing to pay for these assets.
In situations where there is a syndicate, the lenders participating in this group agree to fund the loan together which enables them to spread the risk of default across other entities. These loans are typically larger than a single lender could handle so the role of the syndicate is important. The terms of the loan agreement must be agreeable to all of the lenders, regardless of whether they are known to each other or not.