All I want for Christmas is...a paper on LIBOR Credit Adjustment Spread?

18 December 2020

Phil LloydManaging Director, Head of Customer Sales Delivery

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John Stevenson-HamiltonLIBOR Client Strategy & Engagement

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Luke Hasham-SmithCorporate Financing & Risk Solutions

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Nick KentNatWest Lending Product Franchise Delivery

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Well ok, perhaps not top of everyone’s Christmas list, but for anyone after some holiday reading, the £RFR working group1 has just published a new paper for the loan market. 

Much of the discussion on LIBOR2 recently has been focused first on the fallback protocol, then on the consultations around cessation dates. But with all that becoming clearer, focus is rapidly shifting to ‘active transition’ of LIBOR exposure – i.e. dealing with the legacy backbook.

The £RFR WG Loan Taskforce has released a paper on 18 December setting out the options for credit adjustment spread calculations on active transition of GBP LIBOR loans. And it is worth a read, as it sets out some of the alternatives for pricing transitions and related considerations. 

No idea what CAS, 5YHM, Forward Approach, agree-to-agree or deferred switch mean? Read on.

A quick refresher - who needs to move what by when?

Based on their roadmap, the UK authorities have set a target of end Q1 2021 for no new £ LIBOR loans or linear derivatives (except for risk management of existing positions), with non-linear derivatives following on end Q2/Q3 (noting any new £ LIBOR loans should already contain ‘switch language’ since end Q3 2020). The US authorities have set a deadline of end 2021 for no new $ LIBOR transactions (again with a risk management get out clause for derivatives). 

On the backbook, UK regulators have said they would like to see market participants ‘complete active conversion where viable’ by Q2/Q3 2021 across derivatives, bonds and loans. They have repeatedly warned of the dangers of relying too heavily just on fallbacks, and clearly would like to see legacy LIBOR exposure come right down sooner rather than later in 2021.

Legacy $ LIBOR exposure may take a slightly different path, given recent announcements (see Thanksgiving) about the $ rate continuing to be published until June 2023 (but not for new trades). Though there’s nothing stopping active conversion of $ as well (perhaps other than a thin SOFR3 market at the moment), it’s possible (likely?) the $ backbook maturing between now and June 2023 will simply be allowed to run off.

Pricing the spread for £ loans

Now to those terms....

  • CAS: Credit Adjustment Spread, the spread added to the replacement RFR when moving from LIBOR. The two main ways of calculating this are the 5YHM and Forward approach, with worked examples for both in the paper. 
  • 5YHM: the Five Year Historical Median, the ISDA4 agreed methodology to calculate CAS by taking the median of the daily difference between LIBOR and the compounded RFR over the same period, in the 5 years leading up to the ‘announcement date’ (when ‘X’ is fixed...see You wait for ages for more). Our current best guess is that announcement will come (for all currencies, inc USD) in Feb or Mar 2021.
  • Forward Approach: using the LIBOR vs RFR basis market to calculate the implied future difference between LIBOR and RFR. This is forward looking and so incorporates the time to maturity on the loan. It is based on the methodology used for active transition of derivatives and is what has been used in the bond market.

Two important decisions when considering active LIBOR transition....when to do it, and at what rate. Of course the ‘what rate’ is somewhat dependent on the ‘when’. The options as far as loans are concerned are discussed in the latest £RFR WG paper.

When and how much?

In terms of timing loan transitions, you can choose to move now, set a switch date sometime between now and end 2021, wait for the cessation / pre-cessation trigger (expected Jan 2022 for most currencies, and Jun 2023 for USD) or wait for the first interest rollover after cessation (aka ‘deferred switch’).
Having decided when your loan will transition, you also need to decide at what rate, i.e. what mechanism should be used to calculate the credit spread adjustment that will minimise value transfer. Here the choice is between the 5YHM and the Forward Approach. And if choosing 5YHM, when will the CAS level be set. There are worked examples of both methods in the paper.

So which to choose?

There are pros and cons to each, and there are now precedents in the market for both. Derivatives use the forward approach, and if you need to match a swap to a loan it is more consistent to agree the forward approach for both. 

The 5YHM method has been referenced in some switch agreements entered into recently (e.g. Associated British Ports and British American Tobacco). There is an argument that the 5YHM method is simpler, given it is a number published by Bloomberg (for now as a daily ‘for info only’ number, then once the formal announcement comes probably Feb / Mar 2021 then as a fixed spread per tenor). 

One thing to note – although there seems to be some appetite amongst counterparties to reference the 5YHM number published by Bloomberg now, Bloomberg itself in its usage terms explicitly limits use of the 5YHM number to a secondary fallback reference rate only ahead of it becoming fixed via a ‘fixing event’.

The paper is keen to emphasise that the eventual choice of which method to use is a decision for lenders and borrowers to make themselves.

What does ‘agree to agree’ mean?

The UK authorities mandated that no new £ LIBOR loans should be issued after end Q3 2020 unless they incorporated ‘contractual arrangements to facilitate conversion to SONIA’ ahead of the end of 2021. There have been some deals struck since then where – because of uncertainty around timing, language or fallback rates – not all parties (often in a syndicate) have been able to agree all the terms for a future switch. That is where ‘agree to agree’ comes in – essentially a commitment to revisit the terms in 2021 to establish effective transition or fallbacks.

Maybe it won’t make much difference anyway

The loan paper talks about the difference between snapping the 5YHM CAS at various amendment date (for the loan), at each interest period, at a switch trigger date or at cessation. However this may be a moot point quite soon anyway....if CAS is fixed by an announcement in Feb / Mar 2021, then that is the fixed CAS for everyone referencing 5YHM methodology anyway from that moment on. 

The forward rate would still be different from that fixed 5YHM rate, but as the time running up to end 2021 diminishes the difference between the spreads using those two methods is likely to narrow. So in practical terms it may not make a great deal of difference which method is used, and perhaps the main question is more what timing will suit you.

One thing looks certain, the pace is about to pick up. Protocol effective date, fixing spread adjustment, certainty on cessation date, news on tough legacy....all falling into place in Q1 2021. Expect active transition to pick up.



£RFR working group

UK Working Group on Sterling Risk-Free Reference Rates



London Inter-Bank Offered Rate



Secured Overnight Financing Rate



International Swaps and Derivatives Association

Market infrastructure & regulation

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