The industry wide transition from Libor to a suitable replacement rate, just nine months away under the Adjustable Interest Rate (Libor) Act, is going smoothly, industry observers say. Just one stumbling block in particular remains.
The Federal Family Education Loan Program (FFELP) student loan ABS remains exposed to basis risk under the draft rules. This asset class is more exposed to basis risk, particularly when a transaction has little credit enhancement and excess spread.
FFELP ABS deals have a strong chance of confronting at least two Secured Overnight Financing Rate (SOFR) settings in deals, according to Fitch Ratings. One is the term SOFR for the notes, and another is the 30-day average SOFR for the federal special allowance payment. This payment converts the fixed-rate FELP loans to floating-rate interest payments for FFELP ABS.
Outside of that, Fitch notes, a small number of legacy trusts with swaps maybe exposed to a third setting, that of SOFR compounded in arrears for the derivatives.
Fitch notes that the basis risk could be addressed if the legislation had a carve-out provision for FFELP ABS, and if it suggested different SOFR settings for those types of bonds.
If the final rules do not address FFELP ABS exposure to basis risk, Fitch says, it will review transactions also in light of other developments in the FFELP ABS market.
“Any increase basis risk may negatively affect credit risk,” the rating agency said.
Derivatives are fertile SOFR ground
Other areas of the structured finance market have been fertile ground for SOFR as the Libor replacement, such as the derivatives market, Fitch notes.
SOFR adaptation has increased significantly in 2022, after trending lower than 10% for most of 2021. Futures and options trading based on SOFR surpassed the volume of legacy Libor-referenced contracts, CME Group noted in 2022.
With that success, the CME is proposing to convert all remaining Eurodollar futures and options to SOFR contracts on April 14, 2023.
Leveraged loans
As for leveraged loans, a large portion of them are still linked to Libor, yet many of the loans include fallback language referencing SOFR, according to Fitch. In a higher rate environment, issuers that had planned to transition to SOFR when refinancing the loans have postponed their plans.
“With rates unlikely to meaningfully decline before the expiration of Libor, issuers will need to address Libor replacement directly in the loan documentation,” Fitch said, “or rely on fallback language.”
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Fitch Ratings notes that Federal Family Education Loan Program ABS is more exposed to basis risk when there is little credit enhancement and excess spread.
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