The new Sterling Overnight Index Average, or SONIA, is now well embedded in sterling leveraged finance products, roughly three months after it was first used in the European primary loan market in late March this year, though ongoing discussions around the implementation of a new risk-free rate in the U.S. could yet have implications for this currently settled status.
The long-expected replacement for U.S. Libor has been the secured overnight financing rate, or Sofr, based off the overnight Treasury "repo" (repurchase agreement) rate. However, alternative Credit Sensitive Rates have since emerged from players including Bloomberg, Markit, AFX, and IBA — prompting a more involved discussion around what potential future market rates could look like, which some market participants say may have taken the process back to square one.
"While it had seemed that the U.S. market was settled on Sofr, and on a system that would use a rate calculated on an arrears basis, a critical mass of the market seems interested in a potential alternative," said Jeremy Duffy, a partner at White & Case in London. "There's now a strong and ongoing debate, and at the very core they're looking at whether to apply a risk-free rate calculated in arrears or on a forward-looking basis."
Market participants note that from a returns perspective, issuers will face very little difference in the cost between a rate calculated in arrears and a forward-looking rate. However, a forward-looking measure gives borrowers more of a long-term view on their expected cost of funds — thereby allowing them to prepare for interest payments further in advance — while for a rate calculated in arrears, borrowers can only use models of projection with five business days' notice for the exact cost. Given such key differences, the greater certainty promised by a forward-looking rate may therefore be preferred by many borrowers and sponsors for operational reasons.
However, this ongoing discussion potentially presents a problem for sterling transactions, especially if the far-larger U.S. market opts for a forward-looking rate in contrast to SONIA, which is calculated in arrears.
"For institutions, it would be clunky, but not impossible," said White & Case's Duffy about the prospect of SONIA co-existing with a forward-looking rate. "You can see treasurers and CFOs not wanting to have to adopt two models for their various currency and liquidity needs (which in many cases will also require consideration to be given to the form of risk-free rates to be applied to the appropriate derivatives contracts), and agencies won't want to work with two forms of calculation. That would result in a duplication of effort and a potentially cumbersome process."
Despite such complications, decisions will soon have to be made. U.S. banking regulators have stated that origination of transactions based on one- and three-month U.S. Libor must end no later than Dec. 31. Existing U.S. Libor term loans and CLOs, though, do not have to transition their contracts to a replacement rate until June 30, 2023.
Certainly, the sterling market could offer a roadmap for other markets looking to manage the transition to new risk-free rates. Indeed, market participants have noted how smoothly the process has gone on the whole, particularly utilizing the exposure drafts on the SONIA rate published by the Loan Market Association. "Across the marketplace, almost every agency platform is able to implement these provisions now, or expects to be ready by the end of this year or by a relevant date in 2022," notes Duffy. "Many institutions are of course already equipped, and we have already seen deals done using SONIA."
Pharmaceutical firm Ethypharm SAS was the first non-investment-grade issuer to complete a primary transaction linked to the new rate, wrapping a £245 million term loan B on April 1 that went toward refinancing existing debt. Bankers and investors at the time reported that the process went smoothly, and there has been some €860 million-equivalent of sterling-denominated issuance during the second quarter of the year, according to LCD. Most recently, Valeo Foods on June 30 wrapped a £352.52 million term loan as part of a €1.01 billion-equivalent dual-currency financing backing its acquisition by Bain Capital, with the sterling tranche pricing at a margin of SONIA+500.