The long-awaited deadline to transition away from London Interbank Offered Rate (LIBOR) as a floating rate benchmark index is fast approaching. Starting in July 2023, LIBOR will no longer be quoted or available as a guideline benchmark index for floating rate securities.

New originations in 2022 were required to use a non-LIBOR reference rate. However, as of 1Q23 approximately 75% of the legacy leveraged loan market still had not transitioned to the Secured Overnight Financing Rate (SOFR).¹ Nonetheless, over 90% of LIBOR loans have fallback language,² thus leaving a significant amount that still lack fallback language in their credit agreements. In order to accommodate this transition, the Financial Conduct Authority (FCA) announced it will compel the ICE Benchmark Administration (IBA) to compile and publish an unrepresentative synthetic LIBOR through September 30, 2024.

Synthetic LIBOR

While all new originations in 2022 utilized a non-LIBOR reference rate, and many legacy contracts added fallback language to determine the transition away from LIBOR, some legacy contracts still lack fallback language entirely. With the cessation of LIBOR deadline at month end, the FCA determined that a synthetic USD LIBOR index will be published through September 30, 2024. Synthetic USD LIBOR will be comprised of the Chicago Mercantile Exchange (CME) Term SOFR rate plus the Alternative Reference Rate Committee (ARRC) and International Swaps and Derivatives Association (ISDA) recommended credit spread adjustments (CSA) noted below.

Accordingly, the FCA is attempting to allow lenders without fallback language additional time to properly amend their legacy contracts (mostly non-U.S. law governed contracts). It also allows extra time for legacy contracts to naturally repay or refinance prior to the September 2024 deadline.

Synthetic LIBOR will be used in the U.S. syndicated loan market for loans without fallback language that would otherwise switch to Prime or loans with amendment fallback language that do not have non-representativeness transition triggers. As such, synthetic USD LIBOR is an unrepresentative index, meaning that it is not representative of an interbank lending market.

CSA Trends

SOFR was chosen to replace LIBOR, but inherent differences in the risk profiles of LIBOR and SOFR necessitated a CSA. SOFR is a risk-free rate, and LIBOR is credit sensitive. In order to bridge the variance and historical difference between the two, the ARRC recommended that lenders add a CSA to SOFR. The application and quantification of these CSAs vary across the market.

While some issuers adopted the ARRC 11/26/43 basis point adjustments, some additional CSA conventions emerged.

CSA application and amounts vary between issuers, as no single approach is enforced. The four most used standards are as follows:

1. No CSA
2. A flat 10 basis point CSA
3. A 10/15/25 basis point structure for 1M/3M/6M tenors
4. The ARRC recommended CSA structure

To start 2022, many new originations favored the 10/15/25 structure. According to Pitchbook LCD, approximately 47% of new-issue volume in 1Q22 utilized a 10/15/25 CSA structure, compared to 15% using a flat 10 basis points and only 4% using the ARRC recommendation. Recently, this mix shifted more in favor of the flat 10 basis point CSA and ARRC recommended structure. In 1Q23, 27% of new-issue volume utilized a flat 10 basis point CSA, and 12% utilized the ARRC recommended structure. No CSA remained the highest share contributor with 51% of volume.

While the difference in these structures may seem insignificant, a few basis points of additional interest may become more relevant for issuers as rates continue to increase and interest coverage ratios decrease. The weighted average interest coverage ratio for public filers in the Morningstar LSTA US Leverage Loan Index decreased 52 basis points in 4Q22 to 4.97x and dropped a further 37 basis points in 1Q23 to 4.60x, the lowest level since 3Q20.³

Chris McCann also contributed to this article.

1. “To CSA or not to CSA? As LIBOR deadline looms, a look at market adoption of SOFR,” Tyler Udland, Pitchbook LCD, April 12, 2023.
2. “Synthetic LIBOR: What is it, and does it affect the transition to SOFR?” Pitchbook LCD, April 12, 2023.
3. “Loan issuers confront sliding coverage ratios as rates swell, earnings flatten,” Pitchbook LCD, May 25, 2023.