Ignoring LIBOR Cessation May Raise US Leveraged Loan Credit Risk

Wednesday, January 15, 2020 /09:02 AM / By Fitch Ratings / Header Image Credit: Money Crashers

Potential credit risk may emerge for US leveraged loans if the base rate on loans converts to a higher Prime Rate when the London Inter-Bank Offered Rate (LIBOR) is discontinued post 2021, says Fitch Ratings. Issuers could experience deterioration in coverage ratios, with nearly 90% of 'B' or 'CCC+', or lower-rated Middle Market borrower credit metrics, declining to or below the negative sensitivity set during their most recent rating action.

Most credit agreements have some form of fall back language outlining an amendment process upon LIBOR cessation. If a permanent reference rate replacement is not agreed on among borrower and lenders, standard credit agreement language provides that the base rate on loans converts to the Alternative Base Rate (ABR) in the absence of LIBOR. Most credit agreements define ABR as the higher of the Fed Funds Rate plus 50bps, Prime Rate or LIBOR plus 100bps. Therefore, Prime could, at least temporarily, be used for the ABR, given Fed Funds and LIBOR are typically lower than Prime, resulting in higher interest costs for issuers.

Fitch ran an analysis on a sample of 100 issuers in its portfolio of leveraged loan issuers rated 'BB+' and below. The sample was evenly split between issuers in the Broadly Syndicated Loan (BSL) market, and issuers from Fitch's private rating portfolio, which are predominantly Middle Market borrowers within the direct lending market. For each issuer we replaced LIBOR with Prime, approximated at 5% in our rating case forecast, and examined how the issuer's credit statistics stacked up against the rating sensitivities that could result in a negative rating action.

Risk was mostly among the borrowers rated 'CCC+ and below due mainly to the potential for less financial flexibility as interest coverage weakened. Addressing LIBOR discontinuation early on has the benefit of protecting the issuer from losing its financial flexibility.

The Secured Overnight Floating Rate (SOFR) Compounded in Arrears is emerging as the most likely replacement for LIBOR. SOFR Compounded in Arrears has the advantage of being the actual cost of debt for each interest period. However, the rate will only be known at the end of the interest period, leaving borrowers with very little time between receiving their invoice and paying it. LIBOR is a forward-looking rate allowing issuers to be able to plan out capital allocation well in advance. Secondary loan trading would also be affected by the replacement of LIBOR with a SOFR-based rate that, unlike LIBOR, would not be known in advance. SOFR Compounded in Arrears requires a shift in procedures and significant operational and technological amendments.

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