The transition to new risk-free rates promises a better benchmark for corporate borrowers but is proving a logistical headache. Elsewhere, experts flag slow progress in the loans market and concerns that the new rates might spike the cost of bank borrowing for smaller businesses.

As LIBOR’s 2021 demise in most currencies hurtles closer, corporate treasury teams have limited time to transition their LIBOR exposures to new risk-free rates like SONIA, SOFR and €STER. While treasury teams agree the new risk-free rates are a better instrument, the weighty task of switching every LIBOR exposure, woven into bonds to banks loans and contracts with suppliers, setting up new systems, and venturing into a market where best practice and standards are still evolving, is a source of some trepidation.

Most corporate treasury teams agree that the new risk-free rates are better than LIBOR. LIBOR reflects the cost of banks’ lending to each other so when a crisis spikes like in 2008 or the early days of the pandemic, banks pass on the additional risk to companies that are already paying a margin to their lenders embedded in their cost of capital and funding. It exposes borrowers to rising interest payments just as economic conditions worsen, says Shaun Kennedy, Group Treasurer at Associated British Ports, ABP. “I can’t believe we stuck with LIBOR for so long, it is a terrible benchmark for corporates. LIBOR was designed 50 years ago to pass risk onto companies because at the time banks couldn’t manage that risk, but the world has moved on.” Because the new rates are based on overnight lending markets, less risky than lending funds out unsecured for three or six months, they strip out most of the credit, liquidity and term risk premia common to LIBOR.

Finding LIBOR

Step one in the LIBOR transition involves companies finding their LIBOR exposures, woven like knotweed through bond issuance, bank loans, intercompany loans and derivative portfolios. Although much of ABP’s LIBOR exposure is netting off against itself, Kennedy estimates the company is around 40% of the way through transitioning LIBOR-linked contracts lying in swaps, bonds, loans and US private placements with a notional value of around £4bn. The company made trail-blazing progress transitioning its predominantly sterling LIBOR exposure to SONIA when it moved around £65m worth of bonds to the new benchmark in 2019. A key challenge has been unpicking the different legal wording within contracts, says Kennedy. “There are details around how certain products might react to a permanent cessation of LIBOR which was not envisaged within contracts when they were entered into at the time.”

At London-headquartered British American Tobacco (BAT) Group Treasurer Neil Wadey has mapped all the company’s LIBOR exposures, which mostly lie in the bond portfolio, intercompany and derivatives. A particular focus is on tracking down LIBOR in internal floating inter-company loans, running down exposures and not creating new ones. “We are setting up a process to move all these to risk free rates going forward,” he says.

Even for sophisticated treasury teams like BAT and ABP, familiar with complex regulations, finding and ticking off a dollar LIBOR bond swapped into sterling in one part of the portfolio or a series of LIBOR-linked bank loans in another, is a time-consuming and gruelling process. It leaves John Grout, a retired corporate treasurer and finance director, and an independent expert on the LIBOR Oversight Committee, particularly concerned about the ability of mid-size and smaller companies sitting outside the FTSE100 to successfully manage the process.

His overriding message to this treasury cohort is start now. Many companies will have LIBOR exposures woven into supply agreements, he warns, explaining that finding them will involve treasury working with purchasing and sales departments and dusting off old financial contracts. “Take a sales contract with a buyer on 30 days credit,” he says. “If they pay late, they will pay interest at ‘X’ over LIBOR. Elsewhere a construction group will find changes to their contract pricing will have a LIBOR clause in the relative currencies. Companies may still be operating with a component supplier under a master contract based on LIBOR signed 20 years ago, but who has a copy of the contract?” Elsewhere, he advises companies to look at their pension fund arrangements where they often use swaps to switch investments between fixed and floating and short and long-term rates.

Bonds

Once a company has found its exposure, the transition begins. ABP’s first-of-its kind transition of £65m worth of its bonds to SONIA in 2019 followed bilateral discussions with the company’s end investors. When Kennedy approached the pension funds, asset managers and US life companies holding ABP’s drawn LIBOR debt to say the company was interested in moving to SONIA earlier that year, many weren’t ready. “Some were quite interested, and others said they wanted to see how the market develops,” he recalls. Since that transition however, more of the company’s investors have approached Kennedy ready to switch, he says. “It comes down to saying you are both willing parties and want to transition the product,” he says.

The next step involves drawing up new legal documents that outline the additional spread ABP will add to the margin on the bond. Because SONIA doesn’t have bank credit risk, the SONIA benchmark is generally lower, and Kennedy doesn’t expect any increase in the cost of borrowing as a result of transition. “The process involves agreeing the market implied difference between the two (SONIA and LIBOR) and adding that on top of the instrument for the rest of the life of that particular piece of debt.” As compounded SONIA strips out most of the risk premia common to LIBOR, the bond market has added a premium on top of the compounded SONIA rate based on the average difference between SONIA and LIBOR.

For ABP, which borrows most of its money from non-bank institutions, ditching a floating rate that contains bank credit risk is long overdue. Kennedy is already noticing the new risk-free rate gives a more stable borrowing cost from investors seeking a floating rate, free from the sudden spikes in costs around bank credit concerns. “LIBOR can move around and impact your borrowing costs quite significantly as a corporate,” he says. “It’s frustrating when it has nothing to do with you, more so when you are not borrowing from a bank in the first place.”

Bank loans

Transition in the corporate loan market, were virtually all companies will have some kind of LIBOR loans with banks, has been slower. It is only in recent months that more banks have begun offering non-LIBOR alternatives and flagship corporate names in the sterling market like Tesco and GlaxoSmithKline have taken a lead, drawing up new loan agreements to run off risk free rates. Given the loan market is private, it’s not possible to definitively say how many deals have switched, yet if the Loan Market Association’s (LMA) latest figures are anything to go by activity is still muted and companies – and lenders – need to step up the pace.

Compelled by a lack of leadership, BAT was one of the first companies to structure loans that will switch to risk free rates ahead of the transition when it signed a £6bn multi-currency revolving credit facility with 21 banks in March 2020. “We wanted a transaction that would bridge the cessation of LIBOR beyond 2021, and we hadn’t seen much leadership in the UK market,” said Wadey. Inspired by Shell putting out a SOFR RCF facility, the company decided to structure a commercial transaction coordinated by Barclays and HSBC, banks Wadey names as two of the few leading the LIBOR transition.

The process offers a window into the challenge companies have faced working out their cost of borrowing. Under LIBOR, companies deal with forward looking interest rates, paying interest on the maturity date when they repay the capital, explains Grout. “A company which has drawn on a RCF will know the interest rate and the payment required with the principle six months or three months in advance.” However, under new risk-free rates although companies know how much they have borrowed and are due to pay back, they will only know the interest rate at the end. “The payments process and risk management has to change because you have a retrospective rate,” he explains.

Under the new rates, borrowers will look at the daily interest rates from the time the loan was outstanding and compound it. Alternatively, they could decide to make interest payments on the same day, says Grout. To ensure coupon holders are repaid on the date the coupon falls due, a lag may be introduced whereby companies calculate the compounded interest up to four to five days before maturity. “The market practice around these look back type of arrangements has yet to develop,” says Grout. “If treasury teams decide to pay with a lag, they have to agree how many days they lag. A lot of corporates are saying they are going to wait for market practices to develop. I think by Q1 next year there will be sufficient standard in place.”

For BAT, venturing into this complex and shifting world last March, pragmatism was key. Rather than opting for the lag, Wadey and the team chose for a slightly different 5-day observational shift in the agreement. “There are different approaches, but we decided with our bank group that was the one everyone understood.” Since then, the market has moved towards favouring the lag and although Wadey says he doesn’t like this mechanism as much, BAT is likely to switch to the lag when it renews the 1 year £3bn element of the RCF in March 2021. At which point he also aims to press the button on switching the facility to SONIA once the company’s systems are ready to move to a risk-free rate and book transactions directly into the system. “At the end of the day I can live with an observational shift or lag as long as my system is set up. It’s really an enabling question,” he says, articulating that the key learnings over the last nine months have been around procedure and mechanics, not commercial value.

Rather than these still shifting sands being a cause for concern, proponents say they show that risk free rates are starting to settle on standards and norms. The LMA has published working documents to help guide corporates and says the foundation for new risk-free rates are now in place. Elsewhere, Kennedy says ABP’s treasury team, which has overseen two SONIA-linked deals with banking partners in its loan book this year, has grown comfortable compounding interest and putting a five-day lag into the compounding calculation to ensure a rate five days before the end of the period. “There is now more acceptance of standards compared to discussions earlier in 2020 and at the end of 2019. People talk about lags or an observational shift, but fundamentally you are still compounding a rate over the period and paying at the end.”

Systems

Indeed, setting up new treasury management systems (TMS) that can compound interest and shift accounts from counterparties to new rules could be a bigger headache. BAT runs an integrated system that covers treasury, operations, and risk management. It books loans and derivatives into the system as well as auto-generating cashflows and accounting postings, all set up around LIBOR without any manual interventions. Changing the TMS has involved thrashing out details with suppliers and consultants for the last year, says Wadey. “We weren’t in a great space on this a year ago.”

As for BAT’s derivative exposures, he is still undecided as to whether the company will sign up to the International Swaps and Derivatives Association (ISDA) protocol outlining how companies’ LIBOR-linked interest rate swap exposures will convert to the new risk-free rates. BAT still needs to “get comfortable” with the accounting and tax consequences, he says. “We are looking favourably at the protocol but haven’t signed up to it yet.”

Readying systems has been a similar story at ABP which was reliant on spread sheets for its early SONIA-linked trades as it built and primed a new TMS. Although compounding is complicated, Kennedy reassures it is easily done. “We spent 12 months with our TMS provider going through the calculations. We also completely rebuilt the system, particularly around the accounting model to handle the new products.”

That said, treasury executives are unanimous on the gruelling amounts of time and IT expertise involved in testing and upgrading systems. “It all costs, and it’s not added-value in the main. It just has to be done,” says Wadey whose sympathy goes out to small and mid-sized companies who may not have huge LIBOR exposures, but neither have the resources to put to it.

Reluctance to lend?

The transition poses another challenge for smaller companies that goes beyond the logistical and practical rigmarole. Grout’s analysis of how the loan market will transition to new risk-free rates gives him cause for concern that smaller companies will struggle to tap bank finance. Although the risk of corporate lending hasn’t changed for banks, the way banks recover the cost of the risk they incur in their own business will be different.

Compounded SONIA strips out most of the credit, liquidity and term risk premia common to LIBOR, reminds Grout. “At the moment that risk which is arising from the banks is paid for because it is embedded in the LIBOR. When you go to risk free overnight rate, none of those premia including bank credit risk are in there.” Banks’ enthusiasm to lend is muted at the best of times, he flags. Corporate lending is a tiny part of banks’ overall balance sheets and for many banks it is simply a way to access more profitable business from companies.

Imagine a scenario where a bank’s own creditworthiness has taken a hit after a crisis and a corporate is applying for another round of bank financing. The bank is likely to make the premium over the new benchmark higher, he argues. “Large treasury teams with strong relationships will be aware of this and are able to negotiate with the banks. It’s the smaller companies who are at risk of being told we are going to charge you SOFR + 150bps instead of LIBOR +120bps and they will just have to accept it,” says Grout. “The question is how many points do the banks add, and where they draw the line.”

Moreover, he adds that banks are unlikely to negotiate levels with multiple, individual corporates but will arrange blanket pricing across a suite of clients. “Companies will have to do what they are told, and this will upset many companies,” he predicts. “It won’t be a significant cost, but it will impact marginal borrowers.” Even though rating agencies and auditors have a keen eye on a smooth transition, he is convinced that smaller companies unable to rely on strong bank relationships with lending syndicates will find themselves in a vulnerable position.

The fact that intercompany lending is based on the new, risk-free rates adds another twist that has put revenue authorities on the alert. They are now wary of companies shifting profits between parent and subsidiary companies or seeking lower rates of tax as they transition their LIBOR exposures, says Grout. However, the overriding concern on the road ahead is the workload for small treasury teams with limited regulatory or financial expertise. Hunting down their LIBOR exposure, bilaterally negotiating the transition and producing the necessary working documents is a significant challenge, especially following Brexit and the impact of COVID. Meanwhile, the clock is ticking for banks to ready their systems and begin marketing risk free rate products to the real economy in earnest.