UK financials pilot £4bn Sonia bond switch

Lloyds, Santander UK and Nationwide follow ABP with legacy bond transition

  • An estimated £62bn of bonds linked to sterling Libor are due to mature after end-2021, by which time the rate may no longer exist.
  • Associated British Ports gained noteholder consent to flip a £65m bond to Sonia in June, becoming the first issuer to make the change.
  • In October, Lloyds Bank achieved 99.84% approval to switch a £1bn covered bond, while Santander UK gained consent to transition £550m of securitisation notes. Nationwide proposes to re-hitch £2.3bn of notes to the new rate.
  • Lloyds extended the consent period for transferring its £300m Penarth securitisation to Sonia, on concerns a delayed Sonia-Libor basis pricing mechanism left holders exposed to movements over Brexit.
  • Nationwide addressed those exposure concerns with a forward-starting basis calculation plus additional forward spread adjustment, priced immediately after consent. The issuer achieved 100% approval on its covered bond conversions.

Bit by bit, bond issuers and investors are chipping away at the £62 billion stack of Libor-linked sterling notes due to mature after the end of 2021, when the discredited benchmark will be left to die.

Last June, holders of a £65 million ($84 million) floating rate note issued by Associated British Ports voted to re-hitch the bond to Sonia, the risk-free rate set to replace Libor in sterling markets. While the move was seen as a landmark step in ushering legacy bonds towards the new overnight fixing, market participants were not getting ahead of themselves.

English law typically requires 75% of bondholders to approve amendments via consent solicitation, meaning conversion of a small transaction held by “a couple of friendly investors” – as one market watcher described it – was no barometer for wider transition.

Four months on and further, larger conversions are in the offing. In October, Lloyds Bank won 99.84% approval to switch a £1 billion covered bond to Sonia, while Santander UK won consent to convert two residential mortgage-backed securities (RMBS) worth £550 million to the risk-free rate. Nationwide Building Society followed with a proposal to transfer £2.3 billion of notes – including covered and securitised bonds – to the Libor successor, achieving 100% approval on the covered bonds. In all, over £4 billion of sterling Libor debt has now been approved for transition.

The UK’s Financial Conduct Authority has welcomed the developments. “Following the successful ABP conversion in June, these conversions by Lloyds and Santander continue to show that both issuers and investors can benefit from removing a dependency on Libor given its prospective discontinuation at the end of 2021,” the regulator says in an emailed response.

Experts predict more deals will follow, but concerns over hedge accounting may delay progress in switching bonds. Not all types of securitisation are suitable for the current method of adjusting the coupon under the new benchmark, others warn. And while financial institutions have dominated the early conversions, non-financial corporations may be less amenable to the transition.

A key part of the switchover involves calculating a basis to reflect the gap between Sonia and Libor. Issuers interpolate a basis from the two swap curves for the remaining maturity of the bond, and adjust the new Sonia coupon accordingly. Exactly when this calculation should take place, though, has become a contentious issue.

“Each transaction so far has had different parameters and as such each approach has been tailored,” says Will Appleyard, part of the UK debt capital markets team for financial institutions at NatWest Markets, which led conversions for ABP, Santander UK and Nationwide.

ABP made its basis calculation straight after consent was granted and two weeks ahead of the effective date – pricing the add-on to Sonia at 14.8 basis points.

With the right structuring and the right strategic approach to investor outreach, conversion is eminently doable
Thomas Picton, Ashurst

For Lloyds Bank, there was gap of more than two months between the October 7 consent date and December 27 interest payment date, when the switch was to become effective. The bank opted for delayed pricing, pushing the calculation out to December 17. This has left holders exposed to a two-month period where basis moves could affect the value of the coupon – positively or negatively.

At 12 to 15 basis points across the curve, the Sonia-Libor basis has been stable since the International Swaps and Derivatives Association laid down the core methodology for compounded-in-arrears Sonia as a fallback for interest rate swaps. But the exposure period for Lloyds noteholders stretched across October 31 – the second Brexit deadline, which could have seen the UK crash out of the European Union without a deal.

Uncertainty around the credit and interest rate impact of a no-deal Brexit raised alarm bells over whether the two rates would continue to move in lockstep. The gap between Libor and overnight index swaps rocketed during the 2008 financial crisis when deteriorating credit conditions caused Libor to spike. Any repeat of this widening could translate into a windfall for holders of bonds poised for Sonia transition, but any narrowing would deliver a lower coupon.

The exposure period is also set to include results from Isda’s consultation on a lookback methodology for calculating the credit spread adjustment in swap fallbacks. Of the two options - a five-year median or 10-year mean - the shorter window could drive some basis narrowing, participants say, potentially disadvantaging noteholders.

Covered bond holders – largely bank treasuries – were undeterred, giving a near-unanimous thumbs-up to Lloyds’ plans. A parallel proposal to flip £300 million of secured notes from the bank’s Penarth master trust using the same methodology caused some consternation for the asset manager investor base. To stave off dissent, Lloyds extended the October 14 deadline for the securitisation approval to November 6 – lifting Brexit from the exposure period. The proposal eventually passed without objection, despite a looming UK general election on December 12 creeping into the exposure period, bringing additional uncertainty.

“Covered bonds will pass because it’s bank treasuries and banks want Sonia because it’s a natural hedge on the balance sheet. An ALM desk won’t vote against that, but when asset managers buy bonds it’s a different mentality,” says one UK bank treasury official.

It’s a hitch Santander UK managed to avoid on the conversion of two notes from its Holmes RMBS programme. The bank left just four days between the end of the 21-day consent period and the October 15 effective date. The basis priced immediately after the bondholder consent meeting, using a forward-starting methodology.

“When we launched, investors had a concern about being too far away from the interest payment date given worries around Libor-Sonia basis movements. The timing of the transaction took this into consideration to allow for the margin adjustment to be set as close to the interest payment date as possible,” says Martin McKinney, senior manager for medium term funding at Santander UK.

“Although the basis isn’t moving much, we understood the investor concerns around consenting on day one of a 21-day period and the likelihood voting would happen towards the end of the consent period.”

Nationwide Building Society faced a similar dilemma to Lloyds on a proposed transition for two covered bonds totalling £1.75 billion, and a £550 million securitisation from its Silverstone RMBS programme. With a two-month lag between the November 7 bondholder consent meeting and the January effective date, the issuer priced a forward-starting basis immediately after approval, with an additional forward spread adjustment to reflect the two-month time lag.

“What these transactions demonstrate is a proof of concept that with the right structuring and the right strategic approach to investor outreach, conversion is eminently doable,” says Thomas Picton, a partner in the securities and derivatives group at Ashurst, which advised Santander UK. “If you looked 12 months ago, people would have been concerned about the way amendments need to be made in capital markets deals but you’ve now had successful transactions showing the way and over the next few months that pool will get bigger.”

Belt and braces

The latest flurry of conversions included the first trial of new “negative consent” language included in standard securitisation terms developed by the Association for Financial Markets in Europe. The language, which assumes consent unless holders object, has been baked into newly issued securitisations since late 2017 to ease transition.

Lloyds Bank used “negative consent” for the Penarth proposal. Santander, which had the option in one Holmes transaction, chose positive consent for both – requiring investors to actively vote in favour – due to discomfort around the language.

“While the UK has done many good things, when I looked at the fallback language in my Holmes bond, it’s not prescriptive enough. There’s a lot of interpretation around negative consent. I’m not saying anyone who has used negative consent is wrong in their interpretation, but I believe it’s not explicit enough, so I used positive consent on both bonds,” says McKinney.

As part of its outreach, Santander UK also canvassed investors for views on the treatment of bonds due to redeem just before the all-important end-of-2021 date. McKinney wondered whether there might be appetite to switch those bonds to Sonia in case holders were concerned about ailing liquidity in Libor instruments as the rate limps towards the predicted end of its life.

“A lot of people who buy bonds from our securitisations are other bank treasuries who buy for liquidity purposes. One of the rules of the liquidity coverage ratio is that you must be able to demonstrate liquidity so I wondered if some treasuries might think they would not be able to demonstrate liquidity in these bonds as we get closer to the cessation date. However, at this point there was no appetite from investors to switch this cohort of bonds,” says McKinney.

Banks also face a dilemma over fixed-rate bank capital securities, which are programmed to revert to Libor if call options are not exercised. While it may make sense to flip those with call dates after 2021, McKinney warns that it may send out a worrying message to investors.

“For certain types of callable bonds, there’s a market-wide expectation you will call it and by trying to be proactive you might be shooting yourself in the foot by giving a signal that it might not be called,” says McKinney.

Testing the limits

The conversion floodgates might not be open just yet. A lack of clarity over accounting treatment for hedges on transitioned bonds is a possible deterrent for issuers considering the switch.

“Accounting is a concern for those who hedged debt with swaps and they will want clear direction from the IASB and subsequent EU endorsement to avoid an accidental loss of hedge accounting in the context of Libor transition,” says Francois Jarrosson, director of hedging and derivatives in the global advisory team at Rothschild & Co. “We are expecting this to be in place in December and anyone concerned with hedge accounting is likely to wait until then.”

Consent solicitation is no cure-all for post-2021 Libor exposure across the full legacy bond stock. Globally, Libor underpins $864 billion of bonds maturing after 2021, according to Royal Bank of Canada estimates. Around 80% are dollar denominated and issued under New York law, which requires 100% approval for amendments. The Alternative Reference Rates Committee – the US working group responsible for transition to the secured overnight financing rate – has devised standard fallback language for use in new bonds. The group is also exploring possible legislative fixes, which would automatically re-peg legacy instruments to SOFR in the event of Libor’s demise.

Limitations also exist on English law contracts. In securitisations, the approach has proven effective for master trusts, where a scheduled amortisation allows the average maturity to be accurately calculated. Pass-through securitisations may be problematic under the current methodology.

“The solution being developed for pricing the basis adjustment is based on the remaining maturity, so it is easier for master trusts and covered bonds where there’s a defined end-date. With pass-through products you’ve got a variable weighted average life depending on the prepayment of each tranche, so you haven’t got a defined end-date, which requires more thought,” says Andrei Irimia, in the hybrid capital and liability management team at NatWest Markets.

Additional complications stem from the multi-tranche nature of pass-through vehicles – sometimes across different currencies. Changes to a single tranche impacts cashflows through the whole stack of the securitisation, meaning amendments on any individual tranche would need to be approved by holders on all other tranches.

It’s little surprise that large UK financial entities have dominated the latest crop of transitions. As fully fledged Sonia issuers, large UK banks are ready to handle compounded-in-arrears Sonia, which is UK regulators’ preferred method for Libor fallbacks. Corporates have a harder task ahead of them, however.

“A company might be willing to switch to Sonia when their processes are in place. A little bit of homework needs to be done on internal policies and getting spreadsheets and systems ready to handle the new style coupons,” says Jarrosson. “When you ask for consent, hopefully you are in friendly territory. You are gathering market participants and saying ‘there is an issue, the market is changing and everyone needs to agree to change with the market’. And you are likely to be successful, especially if you need less than 100% to consent.”

Update, November 7: This story was updated to include results from the Lloyds Penarth and Nationwide consent solicitations

Editing by Alex Krohn

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