Implications for rising SONIA rates

As the loan markets battle with various economic headwinds, one particular factor that borrowers, lenders and, indeed, advisors cannot ignore is that of rising interest rates.

As central banks around the world increase rates, ostensibly to tackle rising inflation, it is a timely reminder that the price of a loan is not just the negotiated elements such as margin and fees but also the underlying "funding cost" applied by lenders. For sterling, this was formerly LIBOR (London Interbank Offered Rate) but is now, after an extensive repapering exercise, SONIA (Sterling Overnight Index Average) compounded in arrears.

Since 2008 the market has been used to low underlying funding costs but a very different scenario is coming down the track in the midst of rapidly increasing rates. SONIA, having started the year at 0.19%, is currently 2.19% and forecast by some to rise to between 5.5% to 6% by mid next year.

Such a rise will have a profound effect on the loan markets both in terms of primary activity and ongoing management of facilities already in the market. This will be especially apparent in those sectors struggling to emerge from the pandemic and those most affected by the headwinds caused by the war in Ukraine, rising energy prices and global supply chain issues.

Market participants should be considering the following:-

• How to forecast the unknown: In contrast to a LIBOR-linked loan, for any SONIA-linked loan the total amount due for an interest period will not be known until the end of the relevant interest period. While this has always been a point of concern for borrowers, to date market participants have taken comfort from the historically stable nature of SONIA which allowed parties to estimate the total cost for a particular interest period with a relatively high degree of confidence based on historical information.

However, rapidly rising SONIA rates and associated volatility makes this much more challenging -in particular because SONIA compounded in arrears is calculated using the daily SONIA rate for the relevant calculation period. Therefore, any increases to SONIA after the start of the interest period will be taken into account in the final interest cost – albeit such rate rises will only impact the interest accruing on the days following such a rise.

An absence of certainty around interest costs may result in participants applying an extra degree of caution to ensure there is sufficient free cashflow to service interest which, in the primary market, we expect to result in either lower borrowing levels or tighter financial covenants.

The unknown element of interest costs will also present a challenge for borrowers who are required to deliver budgets and/or provide forecasts in respect of future financial covenants. Borrowers should engage with their lenders early to try and reach a common ground on what reasonable assumptions might underpin such forecasts.

• LIBOR: certainty was useful: Despite its structural weaknesses, one of the benefits of LIBOR vs SONIA linked loans was the certainty of interest costs which a LIBOR-linked loan delivered at the start of an interest period. However, historically LIBOR has been a more volatile rate. By contrast, SONIA has, to date, tracked the Bank Rate quite faithfully. Therefore, if the LIBOR rate was particularly high on any given day, a borrower would suffer that higher LIBOR cost for the entire interest period. However, as a SONIA-linked loan is calculated using the daily rate, for a SONIA-linked loan any changes to the SONIA rate over the relevant period (both upwards or downwards) will be taken into account as the interest period progresses.

Moreover, unlike a LIBOR-linked loan, as lenders do not typically charge break costs for prepaying a SONIA-linked loan early, borrowers may be able to use this flexibility to their benefit if they have free cashflow e.g. avoiding further increases in SONIA by repaying a loan early. Borrowers should be mindful though of any restrictions in their loan agreements in relation to limits on the number of voluntary prepayments in any given period and/or whether any administrative fee for early prepayment applies.

• Check your financial covenants: Borrowers and lenders should carefully consider the impact of rising debt service costs on their financial covenants. Rising interest rates will have an immediate impact on any covenants which are focused on monitoring the ability to service debt costs such as debt service/interest cover. However, participants should also consider whether their financial covenant definitions permit them to take into account any interest rate hedging that they may be considering putting in place to counter rising interest rates. Participants are recommended to carefully check their financial covenants.

If borrowers are likely to require additional headroom on their financial covenants as a result of rising interest rates, they should engage with their lenders early before lenders become inundated with similar requests (as happened to banks in the early days of Covid when many borrowers required emergency liquidity loans and financial covenant waivers).

• Hedging: Low interest rates since 2008 have meant that mandatory interest rate hedging has not been a feature of the market for many years bar certain specific sectors (e.g. real estate finance). However, this is likely to change with lenders and borrowers alike requiring hedging to be put in place for any medium to long term debt. This will no doubt have an impact on the speed of execution for certain transactions.

For those borrowers who are considering putting in place hedging on a voluntary basis, we would recommend engaging with your banks early, as the process for papering such hedging arrangements is not always quick. The potential lead-in time for new hedging may be further extended if the new hedging bank requires additional credit support. New hedging may not automatically benefit from the guarantees and/or security provided to a borrower's lender group. Therefore, to the extent that additional credit support in the form of guarantees and/or security is required from other members of the group, this may need to be provided separately which will result in additional time and cost, especially where multiple jurisdictions are involved.

The key in this period of volatility is communication – the loan market is largely a relationship driven market which works best when borrowers, lenders and advisors are in regular contact.

Ashurst has extensive experience acting for both borrowers and lenders across a wide variety of asset classes within the loan markets. Should you wish to discuss any aspect of this note or anything else relating to the current market dynamics, please do not hesitate to get in touch with any of the contacts listed below or your usual Ashurst contact.