The UK’s regulatory authority, the Financial Conduct Authority, recently announced a proposal to phase out the London Interbank Offered Rate (LIBOR) by December 2021, citing a lack of data to sustain the LIBOR benchmark interest rate. While LIBOR is a key reference rate for the senior loan market, we believe its eventual demise would not cause a significant market disruption.
LIBOR’s Relationship to Loans
One of the key characteristics that investors seek from senior loans is very low duration, which equates to very low interest rate risk. Currently, the average duration of the loan market is approximately 0.25 years. Loans can deliver low duration because they frequently reset their coupons, hence the name “floating rate loans.” LIBOR is the riskless floating rate benchmark that the senior loan market uses as the base rate to which they add their credit spreads to calculate their coupons.
The most commonly used LIBOR maturity is the 3-month LIBOR. If, for example, issuer XYZ Corp. comes to market to issue a new loan today and its credit spread (risk premium above a riskless benchmark) is 400 basis points (bps), and the 3-month LIBOR is 1.30%, the coupon is calculated by adding those two yields together. In this example, the coupon at issuance will be 5.30% (LIBOR 1.30% + credit spread 4.00% = coupon 5.30%). Three months from today when this LIBOR contract expires, the loan’s coupon will be reset. If LIBOR remains unchanged, the coupon will not change. However, if LIBOR increases over that three-month period, the coupon will be reset higher to reflect the rise in LIBOR.
LIBOR + Credit Spread = Coupon
1.30% + 400 bps = 5.30% Coupon Today
1.40% + 400bps = 5.40% Coupon (three months from today assuming LIBOR rose 10 bps)
Given that LIBOR plays such a central role in the loan market, what does a potential phase-out mean for loans going forward?
Our Take: The Senior Loan Market Will Sort It Out
LIBOR is used as a reference rate for borrowing and lending around the world with over $350 trillion1 in financial instruments tied to it in the United States alone. For contrast, the U.S. senior loan market represents approximately $1 trillion2 of that figure. The vast majority of the $350 trillion is made up of derivatives and other structured products. Other financial instruments linked to LIBOR include adjustable rate mortgages and student loans.
While there are unknown variables related to this proposed phase-out, including whether or not it will ultimately take effect, we don’t believe it would disrupt the senior loan market significantly. The typical loan credit agreement contains fallback language that allows the issuer to choose other riskless floating indices to use in setting its coupon should LIBOR be unavailable, such as the Prime rate. There are many other viable alternatives, including the Federal Funds rate or the Treasury “repo rate.” For loans without this flexibility written into the credit agreement, we believe the issuers and their investors will make the necessary amendments to conform to any newly agreed upon standard benchmark. This announcement will undoubtedly cause issuers and law firms to review their existing and future credit agreements to allow for a smooth transition to an alternate benchmark should it come to pass. The good news is that four years allows ample time for market participants and issuers to come to a universally accepted alternative to LIBOR.
Regardless of the ultimate outcome, the financial markets have a long history of adjusting and adapting to changing landscapes, whether they are driven by regulations, the market or other factors. It is important to remember that the “floating rate” characteristic of loans (low duration) is just one of the three unique attributes that market participants demand, with the other two being high income potential relative to other fixed income asset classes and senior secured status in the capital structure for potential capital preservation. Further, corporate loan issuers are equally incentivized to find a solution, as the senior loan market represents their lowest cost of capital. We are confident in the market’s ability to adapt effectively to maintain what in our view are the unique and highly attractive characteristics of the senior loan market. We take comfort in the fact that the whole industry, including the Loan Syndications and Trading Association (LSTA), banks, issuers, lenders and regulators, are hard at work thinking about the best solutions should LIBOR get phased out.
Senior loans are subject to credit, interest rate and prepayment risk, are typically lower-rated and may be illiquid investments (which may not have a ready market).
LIBOR: The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short- term interest rates around the world.
Duration: Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as interest rates change.
This material is for informational purposes only and is not intended to be investment advice, a recommendation, or to predict or depict the performance of any investment.