Brief update on risk free rates and credit adjustment spread
On 31 December 2021 most LIBOR settings were published for the last time as the transition away from LIBOR based financing reached its effective date. On 31 December 2021 all euro LIBOR settings, subject to synthetic settings for certain tenors for certain legacy contracts, all sterling and Japanese yen LIBOR settings, all Swiss franc LIBOR settings and the 1-week and 2-month US dollar LIBOR settings ceased to be published, which in practice means that the ceased LIBOR settings cannot be used as reference rates.
No new use of US dollar LIBOR
Notwithstanding that certain US dollar settings continue to be published until 30 June 2023, no new US dollar LIBOR loan contracts are recommended to be made available past 31 December 2021.
On 20 October 2021, several US agencies including the Federal Reserve Board, Consumer Financial Protection Bureau, Federal Deposit Insurance Corporation, National Credit Union Administration, Office of the Comptroller of the Currency and state bank and credit union regulators published a joint statement reminding supervised institutions to progress towards an orderly transition away from US dollar LIBOR. The statement clarified the meaning of new US dollar LIBOR contracts to include an agreement that (i) creates additional US dollar LIBOR exposure for a supervised institution or (ii) extends the term of an existing US dollar LIBOR contract. A draw under an existing agreement that is legally enforceable (e.g., a committed credit facility), however, would not be viewed as a new contract. However, in respect of non-new contracts entered into on or before 31 December 2021 the joint statement encourages market participants to either use a reference rate other than LIBOR or have fallback language that provides for use of a strong and clearly defined alternative reference rate after LIBOR's discontinuation.
A similar notice was published by the Financial Conduct Authority (FCA) on 16 November 2021 confirming no new use of US dollar LIBOR after 31 December 2021.
Instead of using LIBOR as a reference rate, market participants should be using alternative base rates such as risk free rates (e.g. SOFR and SONIA). As LIBOR has been based on interbank offered interest rates at which a selection of banks on the relevant money market are prepared to lend to one another for a certain pre-determined period of time on an unsecured basis, these LIBOR settings have included premium for bank credit risk and liquidity. Risk free rates on the other hand are based on backward looking overnight rates which do not include bank credit premium or a premium for longer dated funds. Thus, risk free rates have historically been lower than the interbank offered rates, yet the move from LIBOR to risk free rates is intended to be economically neutral. Therefore, in order to avoid value transfers due to transit from LIBOR rates to risk free rates so called credit adjustments spread (CAS) have typically been added to the risk free rates so that the risk free rate together with CAS equals LIBOR. Alternatively, a similar outcome could be achieved by increasing the margin of a risk free rate loan. However, it should be noted that if reference rates are negative, there may be a difference between the outcome of the two alternatives if the parties have agreed on a reference rate floor.
In respect of LIBOR loans that did not constitute day one risk free rate loans (but that were to switch from LIBOR to risk free rates during the course of the term of the facility), it became more or less a market standard in the Swedish market that the relevant CAS was to be based on the IBOR Fallbacks published by Bloomberg on 5 March 2021. Those Bloomberg CAS rates were calculated based on the historic median between LIBOR and the relevant risk free rate over a five-year lookback period from an agreed date. On 5 March 2021, when the FCA announced the dates on which LIBOR rates will cease or lose representativeness, the Bloomberg CAS ceased to float and was fixed for all LIBOR currency-tenor pairs. The Bloomberg CAS rates have also been used in respect of day one risk free rates, but there seems to be less consensus in the Swedish market in respect of CAS applicable to day one risk free rate loans. Borrowers have challenged the viability of the Bloomberg CAS rates and the actual costs of the banks when risk free rates are used, and the lenders have as an alternative instead sought to implement higher margins or currency premiums.
One of the other methodologies that can be used to determine CAS is a forward approach. Instead of basing the CAS on historic median, the CAS is in such case based on forward-looking basis swap market, and involves using forward-looking basis swaps to calculate the implied future spread between the relevant risk free rate and LIBOR. It is calculated as the linear interpolation between differing tenors of LIBOR swaps and risk free rate swaps. The tenor of the basis used is matched to the weighted average life of the loan. So far we have not seen that this methodology has been widely used in the Swedish loan market.
In respect of SOFR loans (i.e. recommended US dollar risk free rate) we have seen that static spread adjustments (10 basis point spread adjustment for one-month SOFR, 15 basis points for three-month SOFR, and 25 basis points for six-month SOFR) have been used in some cases. These rates are slightly lower than the Bloomberg CAS rates and thus more borrower friendly. In this context it should however be noted that lending in US dollars by Nordic banks is often subject to a separate US dollar premium, which is added to the margin and does not reflect the difference between LIBOR and SOFR but the bank’s cost of lending in US dollar.
We expect to see that the question on applicable CAS will continue to be discussed between market participants both in Sweden and internationally during 2022.