Has COVID-19 killed SONIA interest rate benchmark?

With all the challenges that British Banks and businesses are facing at the moment, it would be easy to suppose that the transition away from LIBOR (London Inter-bank Offered Rate) to Risk Free Rates (“RFR”) has been abandoned, or at least shelved.

This is not the case and, while some additional breathing space is being considered, lenders and borrowers should not lose sight of the fact that from 31 December 2021, LIBOR (and benchmarks for other currencies) will no longer be published. But has COVID-19 killed SONIA (Sterling Overnight Index Average) interest rate benchmark?

Transition to SONIA interest rate continues

In a recent update, the LMA (Loan Market Association) confirmed that work on transition is continuing, notwithstanding the pandemic. There is, however, a recognition that some accommodation is required given the extraordinary pressures facing business at the moment.

With this in mind the work has been focussed on those areas which will not interfere with the front line relationship between banks and borrowers. In particular, the administration of borrowing under the various Government loan schemes.

This has meant looking at aspects that can be progressed by banks internally, for example, agreeing conventions for interest calculations, and development of operational systems.

What do the timelines look like now?

• Q3 – 2020
  • Development of LIBOR Alternatives and methodologies for compounding in arrears – unchanged
  • Development and implementation of Operational Systems for Risk Free Rate Loan products – unchanged
• Q3 – 2020
  • Availability of Non-LIBOR Products and inclusion in new LIBOR products of conversion language to address discontinuation – unchanged
• Q1 – 2021
  • The discontinuation of availability LIBOR based products is now not expected until end Q1 2021 – deferred
• Q1 – 2021
  • Forward Looking Term Rate – deferred
• Borrower engagement and education – deferred during pandemic

SONIA interest rate: what progress has been made?

Methodologies and conventions for compounding in arrears

As has previously noted, SONIA interest rate is a daily overnight rate. In order to arrive at an overall rate for any given (historic) period, a compounding exercise must be undertaken to reflect the accrual of interest on an overnight basis throughout the period in question.

This needs to be undertaken by lenders on a consistent basis. A number of conventions have been agreed, including daily interest accrual, compounding only of the RFR including the credit spread (see below), but not margin, and business day conventions.

Work continues on the outstanding issues including:

• Choice of observation shift: Because SONIA interest rate is a daily historic calculation, a convention is required as to when it is calculated relative to payment. The UK approach which has been used in some RFR transactions is to impose a “lag” so that the compounded SONIA rate for an interest period is determined by reference to an “Observation Period” that “lags” a number of business days (five is suggested) behind the start and end of the interest period. It’s not perfect because it means that the actual rate for the interest period may be different from the rate determined in respect of the associated Observation Period, and the mismatch may cause problems with hedge products. Other approaches are being proposed in other markets, particularly the US.

• Use of a compounded index: Consultation has now closed on a daily compounded RFR index in the loan market for Sterling, to complement that already available in US Dollars and Swiss Francs.

• Calculation and rounding for daily interest amounts: Issues to be resolved include how to weight days in a period for which no RFR is quoted, and how to apply interest to the days in the “lag” period, if used.

It is not yet clear whether a single convention for all markets will be agreed, or whether lenders and borrowers will have to apply different methodologies depending on currency. Using different methodologies would create obvious difficulties for multicurrency facilities, and possible market shopping if one methodology gains precedence over another.

Credit adjustment spread

The credit adjustment spread is a concept relevant only to loans transitioning from LIBOR to an RFR, because LIBOR includes an element for credit and term risk inherent in a forward looking rate, which is not present when using an overnight rate. The Working Group has focussed on what happens at the point at which LIBOR is actually discontinued. Some loans may provide for the parties to opt, or be required to transition at an earlier stage.

For transition on cessation, a number of approaches are considered. The ISDA consultation preferred a historic median based on a five year look back, and the Sterling RFR Working Group consultation opted for the same approach. Because it only has to be calculated on one date, and is then applied uniformly, this is a considered to be the more straightforward approach. It is likely that the spread would be published in the run up to cessation, and the long look back is designed to restrict any possible volatility in the spread during the last few days of the lookback period.

For early opt in or trigger event arrangements, the spread is a matter of commercial negotiation between the parties. Thee recent Shell and BAT RFR deals both simply specified the spread figure in the switching provisions.

The LMA is working to develop built in switch mechanisms in its facilities which will allow for transition without the need to amend the facility.

Forward looking rates

Although it remains an ambition to have a forward quoted SONIA interest rate for some limited types of transaction, these are not now expected until early 2021, However, a non-reliance reference or “beta” rate may be available later this year.

So where does this leave borrowers?

For borrowers, little has changed in the mid markets. More recent LMA agreements contain provisions for dealing with the transition from LIBOR, mainly by way of agreement at the relevant time, or by imposition by the Lender of whatever emerges as the market standard. For smaller deals there may be limited appetite for either party at this time to review these arrangements.

Take care where loans include interest rate swaps

The transition from LIBOR, in theory, will not change the cost of loans, so it may seem that there is little to be alert to. Consideration should be given, however, to subsidiary transactions, particularly interest rate swaps. For these, as discussed above, timing mismatches could result in real financial mismatches in transactions designed to hedge loan exposures.

Consider the impact on arrangements and systems

From September, it is likely that lenders will be adopting language being developed by the LMA to provide in more detail for transition (within the current timeframe noted above). As visibility develops, borrowers will need to give some thought to the impact on their own arrangements, and systems.

In particular, borrowers should consider whether they are equipped to monitor and calculate the new rates. Particularly if a quoted index is not forthcoming, as the methodology for calculation is complex, and creates a risk that there will be a lack of true transparency around the rates established by the calculation methodologies.

Think ahead to transition to SONIA interest rate

Those taking out loans over the next few months (including CIBLS Loans) should consider how they will approach transition when it comes. Presently we are seeing a significant proportion of borrowers simply opting for a Base Rate loan, and for smaller transactions this may be the only practical option on offer.

In the mid markets particularly this may deprive borrowers of the ability to access better value cash via an RFR loan, and the potential complexity should not deter borrowers from considering this option carefully before proceeding.