- What is SONIA and how is it different to LIBOR?
LIBOR (the London Inter-bank Offered Rate) is a forward-looking rate available for a range of different periods. With LIBOR, you can borrow today for a three-month (or other) period and know how much interest you will need to pay at the end of that period. As we've seen in recent years, LIBOR is vulnerable to manipulation because it is calculated using forecasts submitted by selected banks.
The Sterling Overnight Index Average (SONIA) is published daily and measures the cost of overnight borrowing on a backward looking basis. If you borrow today for a three-month period you will not know your interest costs upfront but, at the end of the period, your interest will be calculated by reference to each daily SONIA rate during that period.
In practice though, because SONIA is calculated by compounding individual daily rates, by the mid-point of the period you should have a reasonable idea of your interest costs for the whole period. In addition, accepted practice is to use a lag (we have often seen five days) for calculation purposes, so you should know your exact interest costs before your interest payment is due.
- Do I have to transition to SONIA?
Yes – if your existing loans have interest rates consisting of a margin plus LIBOR and a maturity beyond 31 December 2021 (when GBP LIBOR will cease to be published).
The Bank of England working group recommends that all existing LIBOR loans that expire after end of 2021 be converted to SONIA by the end of September latest. In addition, most lenders are now requiring any substantial loan amendment processes to also include SONIA transition – either with effect from the beginning of the next loan interest period, or from a specified future date.
- How will the SONIA transition be implemented in my loan documentation?
As SONIA is calculated in a completely different way to LIBOR, it is not as simple as switching the two terms in your loan agreement – most agreements will need substantial amendment in order to transition to SONIA.
If you plan to make any other amendments to your loan documents in the near future, we would recommend wrapping in the SONIA transition amendments at the same time, so you just have to cover the costs of one amendment process. If not, it would be worth getting in touch with your lender to ensure the transition is dealt with in plenty of time.
Many banks are preparing their own template amendment agreements to use for bilateral lending arrangements where the loan agreement follows a bank standard form.
For syndicated loans with multiple lenders and/or where the loan agreement is based on a Loan Market Association (LMA) template, the market is generally using draft wording published by the LMA, though some lenders have preferred wording which makes a few alterations to the LMA draft. These alterations are not completely consistent between banks yet (and lender in-house views are constantly evolving with updated LMA drafts and wider uptake in the market) but in our experience lender groups can always find their way to wording that works for all parties.
It is also worth checking your loan document to see if it sets out a prescribed process for making amendments of this nature. Older loan agreements are less likely to have a clause of this nature, but newer agreements based on LMA templates will likely include a "Replacement of Screen Rate" clause which sets out some parameters for agreeing new terms. In particular, check what any consent levels are – is this a majority lender decision, or do all lenders (and hedge counterparties) have a say?
- Who pays for amending my existing loan documents?
At the moment, most SONIA transition amendments are being wrapped into wider amendment processes initiated by borrowers, so we have seen borrowers footing the legal bill for amendments to their loan documentation.
However, as we get closer to the cut-off date we will start to see amendment processes which only address the LIBOR-SONIA switch. Most costs clauses only require borrowers to pay for amendments they have requested, so in these instances there is a case for asking your lender if they will pay or at least contribute to legal costs.
- What is the credit adjustment spread (CAS)?
Firstly, let's talk about what it is not – it is not additional profit for your lender, and the transition should be cost neutral for borrowers. The FCA has made it very clear that banks should not use the discontinuation of LIBOR as a way to increase interest rates.
LIBOR includes a credit element to compensate banks for the risk of lending over a term period on a forward looking rate. SONIA, being overnight and backward looking, is known as a risk-free rate, or RFR, so it doesn't include a credit premium and generally fixes lower as a result. To ensure the fair transition of existing loans across to SONIA, a small adjustment must be made to maintain the bank's profit portion of its interest payments (which is the basis on which it would have made its lending decision at the time the loan was originally made).
For loan agreements, there is no real consensus yet as to how the CAS should be calculated. In the hedging market, the CAS is commonly calculated as the median difference between LIBOR and SONIA over a 5 year look-back period, so if you have hedging in place it would be beneficial to mirror this. Either way, your lender should explain to you how they have arrived at the CAS.
While the CAS should only apply to existing loans that are moving from LIBOR to SONIA, and not to new SONIA loans, borrowers might find the CAS reflected in the margins they are offered by banks for new SONIA loans.
- How does it impact on my hedging?
If you have interest rate hedging in place, you should try to manage this transition in parallel with your loan arrangements. The key to minimising unnecessary cost is achieving consistency between your hedging and your loan arrangements – in particular, in the specific methodology for calculating SONIA and the CAS.
Most interest rate hedges will be entered into on templates published by the International Swaps and Derivatives Association (ISDA). ISDA has published a protocol – the IBOR (Interbank Offered Rate) Fallbacks Protocol – which, if it applies, facilitates an efficient transition to SONIA on the occurrence of certain triggers. If your ISDA hedging agreement was entered into after 25 January 2021, or (if your hedging is older) you adhere to the Protocol, these provisions should automatically apply to your hedging. Banks are generally happy to incorporate the Protocol into existing hedging at no cost to their customers.
However, relying on the ISDA Protocol has some pitfalls – the trigger for transition to SONIA may not line up with your loan documentation, and there is no flexibility in the protocol to agree different calculation methodologies with your hedge provider to ensure consistency with your underlying loan documentation – and, as we've mentioned, any inconsistency is likely to result in extra cost to you.
An alternative is to agree bespoke amendments to your hedging to achieve as much consistency as possible between your hedging and loan documentation – whilst there will likely be legal costs in agreeing updating documents, and we have seen some banks charge an execution fee, you may well find this approach generates cost savings in the long run.
Osborne Clarke comment
As we have noted before, the key to managing a smooth transition from LIBOR to SONIA is to start having conversations with your lenders (and hedge counterparties) as early as possible. Now that the LIBOR transition cut-off is approaching, these conversations should now be a top priority for lenders and borrowers alike. Feel free to get in touch with one of our experts who will be happy to support you through this process.