GBP/USD LIBOR transition in Australian loan documents

LIBOR is a forward-looking rate. The applicable rate is fixed at the start of each interest period, meaning parties know the amount of interest to be paid at the end of the period.

RFRs are backward-looking rates. The applicable rate is calculated at the end of the period based on the observable RFR during that period.

The shift from forward-looking to backward-looking rates has been the core technical challenge for market participants – and different methodologies were proposed by industry working groups for market consideration.

IBOR transition is at different stages across currencies, with some having imminent deadlines (eg GBP LIBOR and 2 month USD LIBOR) and others having none at all (eg BBSW/BBSY).

To accommodate this, the LMA/APLMA form documents include flexibility for parties to:

• pre-agree the RFR terms and have these apply either (A) immediately or (B) following a “trigger event” at a future date (a “rate switch agreement”); or
• switch to an RFR in the future by entering into a separate document (called a “compounded rate supplement”) that plugs into the facility.

The approach varies by currency:

• GBP:  As the cessation date for GBP LIBOR is now just a few months away, more recent GBP transactions have generally hardwired RFR terms (often by modifying the RFR rate switch mechanics to apply from day 1).  Even so, what has become apparent is that some lenders’ systems are not yet ready to implement RFRs and various workarounds are being implemented to deal with this in the short term.  We have not seen the use of the compounded rate supplement for GBP loans.
• USD: Fewer USD loans are currently being documented with day 1 RFRs (given the most commonly used 1, 3 and 6 month rates will continue until at least 30 June 2023).  Many USD transactions include rate switch mechanics which will be triggered closer to the cessation date.  Others continue to adopt a “wait and see” approach for the alternate base rate to be agreed closer to cessation date.  Given much can happen between now and cessation date, this approach allows parties to adopt latest market developments at the time, including the potential for Term SOFR to be the rate of choice in certain loan products.

For rate switch agreements, there are some nuances in the “trigger event” definition and switch mechanics to be settled in documentation.

Initially we expected the CAS would be heavily negotiated.  We saw some early movers run auction style price discovery exercises to set the rates.  Others considered formulae for a non-static CAS (although this had its own set of challenges).

This changed when ISDA and Bloomberg published the 5-year historical median spreads to 5 March 2021 (available here).  Those fixed rates were quickly and enthusiastically adopted on most transactions.  In part, parties took comfort from the observable methodology, meaningful sample period (which includes period of disruption in markets) and institutional credibility of those rates.  Aligning with ISDA’s approach also created efficiency for hedging.  We also suspect most parties are also happy to have an easy fix with a clear “market” position to fall behind rather than needing to re-negotiate the CAS for every transaction.

Over the longer term, it remains to be seen whether CAS will be absorbed into the margin and cease to be a separate component of interest.

In LIBOR loans, if a zero floor is applied margin will not be affected if LIBOR falls below zero.

The CAS is a new component of interest between the RFR and the margin, so there was potential for parties to debate whether the zero floor should apply to:

• RFR alone – with interest floored at the CAS + margin
• RFR + CAS – with interest floored at the margin.

We have not seen the zero floor method as a significant issue on transactions – with most applying the floor (if there is one) to RFR + CAS. 

That approach is consistent with an economically neutral transition for a LIBOR loan with a zero floor where LIBOR should (in theory) be equivalent to the RFR + CAS.  It should also reduce misalignments between the base rate and associated hedging.

LMA/APLMA’s proposed drafting for this outcome has been widely adopted – which reduces the RFR so that RFR + CAS = zero.  However, some lenders may prefer alternative approaches where the CAS is adjusted or a hybrid approach where both RFR and the CAS are adjusted.

Fall backs

LMA/APLMA guidance documents include a number of fall-back options if the chosen RFR ceases to be available.

The first fall-back is a central bank rate.  To minimise the economic impact of a shift from an RFR to a central bank rate, some (but not all) documents include an adjustment to account for the spread between those two rates.  There are slightly different formulae in the market to calculate this, but these are generally based on a trimmed mean of the spread over a historical period (e.g. over the preceding 5 banking days where an RFR was available).

The second potential fall-back is “cost of funds”.  There has been some controversy on whether this is necessary or appropriate as a central bank rate should always be available. However, the option for cost of funds can be (and is often) selected as the ultimate fallback for a black swan event.

An area of significant debate (both theoretical and in practice) is whether and how break costs should be charged for prepayments made mid-interest period.  Break cost concepts in LIBOR loan document are based on the assumptions that there are redeployment costs for mid-interest period prepayments (eg if lenders fund themselves by entering into matching term loan arrangements in the interbank market).  

In a world where RFRs apply, borrowers have argued that break costs are irrelevant as there is no matching term funding for Banks.

We have seen a range of outcomes:

• Typical “break costs” construct; 
• Lenders only pass on actual costs and losses (if any) reasonably incurred in administering the relevant prepayment.  Where this approach has been adopted, some borrowers have negotiated exceptions – for example permitting X number of prepayments, or a full prepayment and cancellation of the facility, without any break cost charges;
• No break costs; or 
• “Make-whole” style payments.

Market disruption provisions in LIBOR loans are intended to protect lenders against disruption in the interbank funding market, by allowing them to replace a published screen rate with a rate that reflects their cost of funding where they cannot fund themselves at the relevant benchmark rate. 

Borrowers argue that market disruption provisions are not appropriate in the context of an RFR loan because the RFR is not necessarily reflective of how commercial lenders fund themselves.

This is the most debated point in the market, but ultimately the outcome is binary and the LMA/APLMA documents facilitate either outcome.

If a specified percentage of lenders notify that their funding costs exceed the “Market Disruption Rate”, this can be replaced with the lenders’ cost of funds.  The Market Disruption Rate is defined as the compounded RFR for the relevant interest period plus the CAS.