NEW YORK (LPC) - Companies are switching to short-term Libor rates to cut their borrowing costs as regulators phase out the troubled reference rates that the syndicated loan market and trillions of dollars of investments rely on.
Firms including American Airlines and pump and valve manufacturer Accudyne Industries are choosing short-term Libor rates to cut their interest payments, as the prospect of higher interest rates threatens to increase overall borrowing costs.
The Federal Reserve has increased rates six times since December 2015 and interest rates are expected to rise further, with Bank of America Merrill Lynch expecting two more hikes this year.
“There are borrowers that continue to opportunistically manage their loan book,” said Joshua Thompson, head of the global leveraged finance practice at law firm Shearman & Sterling.
“Any switch between tenors, especially between short-term tenors of one month and three month, are largely driven by technical interest rate reasons,” he said.
Loans are floating-rate instruments and pay lenders a set coupon over Libor, London interbank offered rate, a benchmark set by submissions from banks based on the rate they believe they would be charged to borrow.
Companies that rely on the US$979bn US leveraged loan market have the option to choose a Libor rate that resets every month, three months or six months.
As loans float over Libor, loan interest payments increase as the benchmark climbs. Borrowers raising leveraged loans have typically chosen three-month Libor as the go-to reference rate.
That Libor contract has risen 38% this year to 234bp April 11, which has boosted borrowing costs and is encouraging companies to choose the shorter-dated and cheaper one-month option. One-month Libor was set at 189.5bp on the same day.
The 44bp gap between one-month and three-month Libor is at the widest level since the financial crisis. This is due to questions over US companies repatriating cash under the new US tax regime and uncertainty in money-markets, among other issues, according to Mark Cabana, head of US short rates strategy at Bank of America Merrill Lynch.
“Issuers have preferred to fund around the three-month level and as a result, [these uncertainties have] caused issuers to pay more for that type of term funding,” he said.
The swing comes as markets prepare for Libor to be phased out in three years after bankers were found guilty of manipulating the benchmark in the aftermath of the credit crisis. Last year, Citigroup, Deutsche Bank and HSBC all agreed to settle a US class action brought by futures traders accusing them of manipulating Libor.
In July 2017, Andrew Bailey, chief executive officer of the UK’s Financial Conduct Authority, said Libor must be replaced by the end of 2021 due to insufficient transactions underpinning the rates.
The New York Federal Reserve introduced an alternative on April 2, the Secured Overnight Financing Rate (SOFR), which is based on the overnight Treasury repurchase agreement market. SOFR was set at 1.80% April 2 and dropped to 1.75% on April 10.
Publishing the new rate is the first step in a multi-year transition away from the existing benchmark, but questions remain for investments set to mature after 2021 that currently use Libor and want to retain the flexibility to move between different tenors.
“There is little doubt Libor will get used less and less, but [markets] still needs to deal with the fundamental question that there are tenors out there, and we have to have some liquidity in the market before new products are introduced and older products are transitioned or grandfathered in,” said Adam Schneider, a partner at consulting firm Oliver Wyman.
After Bailey’s comments, in order to prepare for life after Libor, more flexibility was added to loan documents to make it easier to change reference rates.
Loan credit agreements added provisions that allow the agent bank and borrower to decide on an alternative benchmark, which offer lenders the ability to object or consent to the change.
American Airlines noted the efforts to replace Libor in a February 21 regulatory filing, saying it is impossible to predict the effect of a benchmark change, but if interest rates increase as a result of the move, its expenses will also rise, which may impact its ability to make interest payments.
Collateralized Loan Obligations (CLOs), the largest buyer of leveraged loans, also added language to allow for a Libor alternative, which often requires a majority of one or more classes of the funds’ investors to approve a change.
Some deals also say the new rate will be the one recognized as industry standard by the trade group the Loan Syndications and Trading Association (LSTA) or the Alternative Reference Rates Committee, a group tasked with identifying best practices for alternative reference rates.
“There is a lot of work to be done before 2021, but the objective is – if Libor does go away – to get to a new reference rate with no value transfer between the borrower and the lender,” Meredith Coffey, the LSTA executive vice president of research and regulation, said.
“If we do everything correctly, the new all-in interest rate and the old all-in interest rate should look pretty similar.”
Reporting by Kristen Haunss; Editing by Tessa Walsh and Michelle Sierra