By Joshua Roberts, Associate Director at JCRA
With a little over two years to go until Libor loses its regulatory support, GBP debt and derivative markets are increasingly focussing on the transition to Sonia. As outlined in our recent whitepaper, the key task for borrowers begins with identifying any exposures to Libor in their existing contracts. After this, they will be able to assess whether their current “fallback” provisions (i.e. the clauses dictating what happens if Libor is either unavailable or deemed unfit for purpose) are sufficient, or if they require amendment.
As the transition date draws closer, those considering new financing agreements should also be asking whether they should be borrowing on Libor in the first place. To date, the lack of development in the Sonia lending market has made this a moot point for those borrowing from banks or private debt funds. Libor loans have been the only ones on offer. But with a variety of banks now developing their Sonia product ranges (for instance, NatWest’s recent loan to National Express), borrowers will increasingly be presented with a genuine choice.
How do you solve a problem like Sonia?
The first issue to consider is whether the borrower’s systems and cash arrangements are sufficient to cope with the structural differences between Libor and Sonia. Unlike Libor, Sonia is an overnight rather than a term rate. It also fixes in arrears rather than in advance. So, whereas a single Libor fixing at the start of an interest period determines the interest cost for the whole period, calculating the interest cost on a Sonia loan requires every daily Sonia fixing from the relevant interest period. The immediate consequence is that Sonia borrowers will have significantly less notice of their interest cost before the payment is due.
This loss of notice causes understandable concern amongst treasurers. However, it is likely to be less of a problem than it appears for two reasons. Firstly, the current convention for loans and publicly traded bonds that reference Sonia is for interest payments to be made a few days after their period end date rather than immediately. To date, the typical length of this “lag” has been five business days, although one could imagine lenders extending these terms for smaller borrowers with different cash management needs.
Moreover, the “compound Sonia” rate for a given period is essentially an average of where Sonia fixed over that period. As a result, while each daily fixing is required for the calculation, there is a limit to how much of an impact the later fixings can have on the overall rate. Sonia closely tracks the Bank of England Base Rate, so the greatest changes would be expected in response to a mid-period change in monetary policy. By two-thirds of the way through an interest period, a hike by 0.25% (the typical increment by which the Bank raises rates) would change the final compound rate by only 7.5 basis points. So while Sonia borrowers will not have complete certainty of their interest cost until the period end date, they will have a reasonable estimate in the few days beforehand.
Hedging a Sonia loan
The other concern for those looking to borrow on Sonia is the relative lack of development in its derivative markets. The last few months have seen significant progress here: in the first half of 2019, for instance, 45% of all sterling swaps traded referenced Sonia rather than Libor. As a result, those wishing to borrow on Sonia and subsequently fix their interest rate should have few difficulties doing so. On the other hand, the market for Sonia options (which includes caps, floors and swaptions) is still in its infancy and obtaining tradable quotes for these can be difficult or impossible. This means that those looking to hedge their Sonia exposures without fixing them need to look to more creative solutions, like using a Libor derivative as an imperfect “proxy hedge”.
Faced with these obstacles, many may conclude that it is better to wait for the market to develop further before switching over to Sonia. Nevertheless, it is still worth considering how to approach them. It appears increasingly certain that those currently signing new Libor-referencing contracts will need to shift them over to Sonia at some point in the next two years. Considering the challenges in advance will make the transition much easier.