Economic activity in Q2 2019
U.S. economic growth remains strong.
This is highlighted by Q1’2019 GDP growth of 3.1%. However, a potential downward revision of consumer spending data could suggest that the GDP growth momentum will be difficult to maintain.(1)
High yield volume increased. Volume increased by 19% to $132 billion in Q2’2019 from $111 billion for the same period last year.
Leveraged loan volume declined. Volume decreased by 37% to $239 billion in H1’2019 volume, compared with $372 billion for the same period last year.
LIBOR is set to retire and banks need a new rate benchmark
In light of the news that the London interbank offer rate (LIBOR) will end by the end of 2021, there is an intense focus on replacing it. Across the world, regulators are suggesting alternative rate benchmarks, and in the United States, the SEC has provided guidance as well. What’s common about the new recommended rate benchmarks is their use of actual transactions as a benchmark rather than survey data which served as the foundation for LIBOR. Regulators hope that a more factual approach can prevent rate manipulation.
In the United States, the Secured Overnight Finance Rate (SOFR) has become the recommended option, but there is some concern about the stability of this rate causing some to wonder if multiple benchmarks will be needed to accurately set rates moving forward. Another option, the Sterling Overnight Interbank Average (SONIA), which uses overnight risk-free rates that are compounded in arrears, is also viewed in a positive light by many regulators.
With rate uncertainty looming in the future, banks and borrowers can be proactive today in order to avert future challenges around rates.
Floating rates present challenges
The elimination of LIBOR leaves the interest rate charged on floating rates in a state of uncertainty. Standard loan documents often do not address what happens in the event LIBOR becomes unavailable, which could result in confusion for borrowers and lenders. And when they do address the issue, prime rate is used in lieu of LIBOR, frequently not adjusting the interest rate spread. As a result the borrower will likely face a higher rate.
Best practices for addressing LIBOR in standard loan documents
Loan documents should identify a replacement benchmark for when LIBOR becomes unavailable, and provide an adjustment of the interest rate spread based on the difference between LIBOR and the replacement benchmark. This approach will maintain the interest rate both the borrower and lender intended on initially.
Next steps for borrowers and lenders
Borrowers and lenders should review their loan documents (including any interest rate swap agreements) to determine which loans utilize LIBOR as a benchmark. For loans that use LIBOR as a benchmark:
Whether it's a new or existing loan agreement, borrowers should be taking the appropriate steps to address the retirement of LIBOR. It is important to consult with your advisors to conduct an assessment of the financing situation and a full review of the agreements - to address potential issues down the road.
(1) Source: the Bureau of Economic Analysis; The Bureau's second-quarter advance estimate released 7/26/2019 is based on source data that are incomplete or subject to further revision by the source agency. The "second" estimate for the second quarter, based on more complete data, will be released on 8/29/2019.
(2)Sources: Capital IQ, Federal Reserve Bank of St. Louis LCD Quarterly Leveraged Lending Review: 2Q 2019, and Interactive High Yield Report 2Q 2019