Big milestone in Libor demise barely budges the loan market

London

THE next major milestone in Libor's years-long demise is only three-and-a-half months away, but the vital loan market has done very little to show it is ready.

After Dec 31, new financial products can't be tied to the London interbank offered rate (Libor), a consequence of regulators wanting to extinguish Libor following a rigging scandal a decade ago.

The leading heir for US dollar loans, the Secured Overnight Financing Rate (SOFR), has so far gained little traction. Ford Motor is doing the first syndicated US corporate loan linked to SOFR, while the acquisition of chicken processing company Sanderson Farms will be funded with a loan that initially uses Libor but will automatically shift to SOFR in 2022.

That's largely it for prominent new deals. The slow process may be due in part to cost differences when selling debt tied to each benchmark. Investors are especially waiting to see how the US$1.2 trillion leveraged loan market makes the switch with delays preventing corporate borrowers from getting a dry run with SOFR before Libor ends. That raises the possibility of widespread confusion in the market come January.

"One of our main concerns about the transition is a worry that we've had for a while now: inertia in the loan market, especially the syndicated loan market," Michael Held, an executive vice-president at the New York Federal Reserve, said last week. "Lending in alternative rates is not where it should be at this point."

It's not all gloom and doom. Trading in SOFR derivatives rose to 12.5 per cent of the dollar-linked market in August from 7.4 per cent in July, according to the International Swaps and Derivatives Association. The rest was in Libor contracts.

While still relatively tiny compared with the incumbent, signs of life in SOFR derivatives at least show the ecosystem for the alternative is picking up. This could help SOFR lending take off, since lenders like to manage their risks by using a derivatives market.

"For banks to feel comfortable making SOFR loans, they also have to be confident in the SOFR derivative infrastructure," said Gennadiy Goldberg, senior US rates strategist at TD Securities. "The SOFR derivatives market received an enormous boost in August," he added. "Banks are certainly busy making the transition as we speak."

That said, at least US$976 billion of loans are unprepared for a smooth exit from dollar Libor, leaving banks and borrowers to hammer out a solution for most of them before the rate fully expires in mid-2023, according to estimates from research firm Covenant Review.

As far as new loan sales go, 92 per cent of deals in August had hardwired fall-back language, according to Covenant Review. Yet 80 per cent or so of leveraged deals in a key US$1.2 trillion index lack such language from the Alternative Reference Rates Committee designed to shift them automatically to replacement benchmarks, Ian Walker, head of legal innovation at the firm, wrote in a July note. That leaves them facing an uncertain legal future when the benchmark ends, with challenges expected as companies look to refinance their debt.

There are other reasons for slow progress, said ING strategist Padhraic Garvey. He added that official endorsement of term SOFR - or versions of the rate with tenors beyond overnight - arrived relatively late and a dominant rate to replace dollar Libor hasn't yet emerged.

"Should the regulator come in harder? I'd suggest that should be saved until Jan 1, 2022," he said. "From that date there are no excuses, but for now there are many." BLOOMBERG