CJ Doherty: Welcome to the Lending Lowdown. I'm CJ Doherty, Director of Analysis at LSEG LPC. And back in 2017, the Financial Conduct Authority, which regulates Libor, announced it would no longer guarantee Libor production beyond 2021. And this was extremely important for the financial markets as Libor was one of the most widely used reference rates across loans, derivatives, securities and mortgages. And in fact, estimates of the size of contracts tied to Libor at the time were in the 200 trillion range and the 2021 date was subsequently extended to June 30 of this year. And as the June 30 Libor Cessation deadline approaches, I thought it would be timely to take stock of the current state of affairs in the syndicated loan and CLO markets. And who better to sit down with and discuss it than Tess Vermani, Deputy General Counsel and Co-Head of Policy at the LSTA? So Tess, thanks for joining me.
Tess Vermani: Terrific to be here. Thanks CJ.
CJ Doherty: Thanks. And so Tess, you've been immersed in all things Libor and its replacement rate in the US. Which is SOFR since the demise of Libor was initially announced back in 2017 and now the June 30 deadline is practically upon us. So let's start off by asking you to give us an overview of how the shift of Libor has progressed. What has progressed well and what are you keeping an eye on?
Tess Vermani: Sure, no, it's a great question, both personally and from a market perspective. I'm very happy to see the June 30th date finally come and sort of move to the cleanups left after the majority of transition happens at that date. So I think we are in good shape. I would caveat that with we do tend to be a last minute market in the loan market and so as I guess we could have expected, market participants are certainly going to be working up until the last minute. But I do think we're going to find that the transition was successful with few problems we have seen in the last couple of months a real ramp up in fallback amendment activity. I think just looking at May LevFin Insights had recorded nearly $120,000,000,000 of fallback amendments and other transition activities. So that is not insignificant. And the latest JP Morgan research shows that nearly half of the JP Morgan Leverage Loan Index is tied to SOFR. A little less than that, but that data is also somewhat lagged. So we've definitely made a lot of progress. Now half of the outstanding loans being tied to Libor isn't a small number. It certainly means there is a lot of wood to chop. However, there is a path forward in doing so because of those. Outstanding loans, you have 35% of them having hardwired fallback language, which means that there'll be an automatic transition to term sofa after June 30 and only about 8% of outstanding live or loans have no fallback language. But again, that number is small enough where parties to those transactions can come together to find a path forward how to transition. And in some cases, perhaps those loans will actually look to synthetic Libor for some time. So I think all in all, we are going to need to keep up the momentum through June and the few weeks after. But we are in a good place and I think we will look back on the transition as having been relatively smooth.
CJ Doherty: Okay, so good progress there. And then secondly, I want to ask for outstanding loans there's. The libor act. How relevant is this act for loans?
Tess Vermani: It's a good question and one, we get a lot. The Libor Act is incredibly significant for most legacy financial instruments tied to Libor because outside of the loan space, you really don't see the type of flexibility that we have in loans where borrowers can come back to their syndicate and the agent can manage an amendment process. So for most financial instruments, the Libor Act was really key for them to be able to transition. It has less relevance for loans, particularly syndicated loans. It's note that the Libor Act carved out syndicated loans explicitly, but by the terms of the act, a credit agreement that references a specific benchmark rate would be out of scope. And given the prevalence of ABR as an ultimate fallback rate in credit agreements, it's basically understood that nearly all syndicated loans will be out of scope for the Libor Act. However, because the vast majority of outstanding loans have either hardwired or amendment fallback language, with only about 8% of Libor loans having just a fallback to prime, call these your pre 2018 deals before fallback language was included in credit agreements, that's a pretty small universe. And so while the Libor Act is not so relevant, it's also not so necessary.
CJ Doherty: Got it. Yeah. And then I want to ask more about SOFR now. Is it performing the way the market expected, most notably in this rising interest rate environment that we're in?
Tess Vermani: Well, I'll say term SOFR is performing as it is meant to, but perhaps not entirely as expected by the market. So if we think about it, the term SOFR curve is based on SOFR futures trading, which is fundamentally different than the Libor curve, which is based on a mix of interbank lending transactions and best judgment values. So this means that term SOFR reflects the market expectation of where Sofa rates will be at one month. Three months, six months. So this means that if the market expects interest rates to hold or even reverse, term Sofa will be flat or possibly inverted. So, as market participants think about spread adjustments and comparing where rates are today, it is important that they keep in mind the different rate behaviors in considering these spread adjustments. Where we are today, the SOFR curve is pretty flat. And where we are today, six month term SOFR is slightly lower than three month term SOFR.
CJ Doherty: Okay. And going back to the loan market, specifically, it looks like the investment grade loan markets, it seems to have had a smoother transition to. Sofer what's been the driver of this?
Tess Vermani: So I think there are a couple of factors that have led to this. One is that it is just the relationship nature of the market and the fact that many of these investment grade facilities may be 364 day facilities in which there are really natural opportunities to make the transition. But probably the largest distinguishing factor between the investment grade space and the institutional loan space is the negotiation over credit spread adjustments or CSAs. We have seen very active negotiations over CSAs in the institutional loan market and that has been something of a headwind to transition. Borrowers are also more sensitive to any real or perceived increase in rates in the institutional market. So this is a very important conversation for them. So I think that is largely why there has been the difference. But again, I do think that the building blocks are there for a successful transition in the institutional space as well. It's just been slower.
CJ Doherty: Yeah, got it. And just to move on, or a little bit error, you referenced synthetic Libor. To what extent are borrowers likely to use synthetic Libor, which I think is going to be published until September 2024?
Tess Vermani: Yeah, this is probably the biggest area of focus right now and has been since the FCA made their announcement. So, just as a reminder, the synthetic Libor is going to be equal to term Sofa plus the arc spread adjustments. So the synthetic Libor rates are actually the values are going to be the same as the hardwired fallback language rates and what we're seeing in many of the fallback amendments. The difference is that the synthetic Libor rates are going to continue to appear on the Libor screen. So at the same screen that you're looking to Libor today, you're going to have a rate available after June 30. However, it's going to be no longer representative, which is relevant for many credit agreements, but also it's going to be using this alternative methodology where it is going to in fact be representing term SOFR plus the relevant spread adjustment for that tenor setting. And so synthetic Libor is of keen interest. Think for those loans that don't have fallback language. So where the credit agreement could, by its drafting, look to the synthetic Libor rate because it's a rate that appears on the same screen, there's no discussion in the credit agreement about the methodology used or anything like that. Then synthetic Libor offers a runway for a loan that would otherwise be going to prime. So for that universe of loans, I think borrowers and agents are going to be looking at where synthetic Libor can be used, where it needs to be used based on the drafting. I mean, one thing that has made the Libor transition so much fun is just the variety of drafting. We really don't have standardized credit agreements and so there is a lot of variability in the way that library definitions are drafted and market disruption provisions. And so it's very hard to speak sort of categorically or even in real broad brush strokes about credit agreements. But generally speaking, those loans that wouldn't have a good way to avoid prime after June 30 will be looking to synthetic Libor. And then even in the amendment approach loans, because there was such evolution in fallback language and it really was such an iterative process, there is fallback language out there, amendment fallback language out there, that would have the ability to look to synthetic Libor if an amendment hasn't taken place. And the Libor definition was drafted in a way that would look to the Libor screen. And so even in some loans where there is amendment fallback language, but an amendment hasn't taken place yet, we could see some of those loans looking to synthetic Libor. So certainly will be there for pockets of loans. Again, it's not the end of the line. It is still let's call it a holding pattern until remediation can occur. But I do think that loans will be using synthetic Libor for some time. Loans that will not be using synthetic Libor are of course hardwired fallback language loans because they have a trigger that includes Libor no longer being representative. And we know that the FCA will be making that statement. Also, loans with arc amendment approach language will not be looking to synthetic Libor because the way the Arc language worked, it has a benchmark on availability period concept where if there's an announcement that Libor is no longer representative, the credit agreement will look to prime. So in those loans, if there hasn't been an amendment to transition to SOFR, then after June 30, the credit agreement will shift to prime. And so at the next interest reset prime would be the relevant rate unless a transition amendment takes place. So certainly some pockets where synthetic Libor will be used and certainly some pockets where we know synthetic Libor will not be used. Okay,
CJ Doherty: Great. And you've touched on credit spread adjustments already and there's been much discussion about them in the last couple of years. How relevant will they be going forward in the loan market?
Tess Vermani: I think they are probably going to work themselves out of the market. CSAs really don't have much significance outside of the transition context. They certainly have for this period because CSAs have been important to have as a discrete component for some of the way fallback language was drafted to make sure that a adjustment was included. It also, I think, gave some very helpful transparency into the transition process as loans fall back from Libor to SOFR. But going forward it won't serve any specific function and it makes much more sense for the market to just price on SOFR and we're already seeing in new loans that CSAs aren't as relevant. Yeah.
CJ Doherty: Okay, and I want to talk a little bit about CLOs now. Obviously the largest buyers of leveraged loans and the need for more negotiation around credit spread adjustments when it comes to institutional loans. So CLOs are hardwired to use the Arc recommended spread adjustment when it comes to their liability notes. But if the underlying loans in the CLO price with a flat ten basis point CSA, then CLOs must pay the difference to their investors and obviously that's not great for CLOs. How is this playing out in the market?
Tess Vermani: Yeah, this has been a huge point of focus the CSA question over these last months of 2023. At the end of 2022 and even in January we saw quite a few transition amendments get done with ten basis points or even zero basis point CSAs. Then I think CLO managers and particularly CLO investors really started to focus on this issue and what it would mean if there is a disconnect in the CSAs and loans versus what the CLO notes are going to pay. And I think it became one of the main points of focus and we've seen a really meaningful shift over these last few months toward Arc level CSAs and Fallback amendments. In fact, I think the last data I saw was something like over 75% of CSAs included in May transactions were Arc level of 1126, 43 basis points for one, three and six month term so far. So that's a meaningful shift. It doesn't mean that some deals don't still get done with ten basis points or less if maybe lender consent isn't needed or if the term loan B piece is much smaller compared to the level of, say, bank lender representation. But definitely the gravity has.
CJ Doherty: Okay, great. So final question for you Tess, before we wrap up. Is will concern around so. Adoption largely be in the rear view mirror by July or do you think the market will experience growing pains for a bit longer?
Tess Vermani: Yeah, so I mean, look, years of preparation have gone into this transition and while this chapter of the transition going from really moving outstanding loans to Sofa is certainly the hardest compared to say the end of Libor originations that we saw starting in 2022. But I think the outlook is good. I do think it's helpful to remember that while June 30 is the key date for credit agreements and for when the agreements themselves transition rates, it doesn't mean that it's going to be like flipping a light switch from a market's perspective for a few reasons. One of course is that the credit agreement may now have as the reference rate term Sofa, but it won't actually be used until the next interest election date. So until the interest resets, you won't look to using that replacement rate. And that is important too because that would mean that even where a borrower elects, say six month Libor in that last week of June, that Libor rate will continue to apply to that six month period. Meaning that the first interest reset that would look to a non Libor rate won't be until December. And so if the borrower and lenders had not been able to conclude a remediation amendment by the end of June, that gives six months of runway to get that amendment completed, which I think will be really helpful for some borrowers. But again, between when different interest rollovers occur after June 30, together with the possibility that borrowers will make some longer dated Libor elections in the next couple of weeks, I think it will be still something that is kind of actively occurring throughout the summer in terms of transition work, perhaps even for some loans. You'll see this happening in December but I think that that will just be working itself through and so by the end of the year for sure we will have had the market fully transitioned to SOFR.
CJ Doherty: And on that note, we will wrap up for today. Tess, thanks for joining me and sharing your insights. We look forward to seeing how things play out with the end of Libor and also with SOFR and credit spread adjustments going forward. I invite all our listeners to check out our loan market news and analysis@loanconnector.com. Follow us on Twitter at LPC loans. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.
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