Are there any challenges with switching to overnight SONIA compounded in arrears for aviation finance?

Most aircraft financing is US Dollar-denominated, which means that a US Dollar replacement benchmark (such as the Secured Overnight Financing Rate, or SOFR) would be relevant. The challenges associated with the transition away from LIBOR for US Dollar aircraft financings are substantially the same as for other financings and other currencies – has a market consensus emerged as to how transactions will be treated? Is there a market consensus in relation to the payment and calculation conventions associated with the replacement benchmark? Are Banks operationally ready to transition away from LIBOR and to calculate interest on a compounded in arrears basis? And what are relevant regulators and loan trade associations saying? Whilst a compounded in arrears calculation would be acceptable for US regulators, the “hard-wired” benchmark fallback language recommended by the Alternative Reference Rates Committee favours a “Term SOFR rate” (i.e. a forward-looking interest rate which would behave in a similar way to term LIBOR rates) or, failing which, an overnight rate calculated on a daily simple basis. Term SOFR rates are expected by the end of the first half of next year, but will require rapid development of SOFR derivatives markets in order to achieve this. A particular challenge for aircraft financings is that they are typically interest rate hedged, and so the market will need to come to a consensus as to how loans and related interest rate hedges will interface.

Are there any other alternative rates that could be used for aviation finance transactions?

Aircraft financing is overwhelmingly raised in US Dollars, but Euro and other currency financings are occasionally entered into. The parties will always be free to select another replacement benchmark so long as it isn’t based on LIBOR. For example, it will be interesting to see whether US airlines raise financing with their domestic lenders on the basis of AMERIBOR or some other replacement benchmark rate.

What are the practical considerations of moving to a new rate specifically for aviation finance loans, in particular, what elements of aviation finance documentation should be analysed and considered?

One of the major trends in aircraft financing over the last ten or more years has been the rapid rise of operating lessors, which now own and lease around half of the global aircraft fleet. Most borrowers of aircraft are now therefore lessors. Operating leases typically charge fixed rate rentals, which means that interest rate hedging (to fund floating rate loan interest payments) is extremely common. Aircraft financing counterparties will need to decide whether they follow the ARRC recommended waterfall of SOFR rates (referred to above) in order to calculate interest under their loan agreements, or whether they elect to follow the calculation convention selected by ISDA (a daily compounded in arrears calculation). Whilst a difference in approach between the loan and the swap may not give rise to a particular “basis risk” under aircraft financings (at least between daily simple and daily compounded interest calculations), a market consensus needs to be reached.

Is there any impact on lease documentation?

Lessors and lessees will need to consider how LIBOR transition is achieved under their operating leases. Most operating leases do not make provision for LIBOR transition, nor do they provide for a fallback rate in the event of LIBOR cessation beyond requesting reference bank rates (which is not itself an effective fallback, since a shrinking number of reference banks are prepared to quote a rate even now).

At this stage, where LIBOR is referenced in operating leases, it would be prudent for leasing companies to amend existing leases in order to include replacement benchmark language. This will ensure that LIBOR transition triggers are broadly consistent between operating leases and any related financing and hedging arrangements; and it will also ensure that appropriate interest calculation methodologies and market approaches can be introduced into operating leases by amendment at the appropriate time.

Where fixed rate operating lease rentals are payable, the parties might also consider an alternative basis on which to calculate default interest under the lease which avoids SOFR and credit adjustment spreads altogether, but this would require careful thought, particularly regarding the way in which this interacts with any upstream financing.

Leasing parties will need to consider an appropriate costs allocation for amendments of existing leases.

Another point to note is that fixed rate operating lease rental calculations are usually constructed from a swap screen rate for an agreed term (taken an agreed number of business days ahead of the rent calculation date), and lease rentals cannot be adjusted after the event.

The swap screen rate will itself have been constructed from an interest rate exchange which assumed that 1-month LIBOR rates would remain available for the duration of the swap period, which means that such correlation as previously existed for leasing companies between outgoings (funding costs) and income (lease rental) is lost. Whether this creates a windfall or a loss for leasing companies will depend on what happens to SOFR rates in the future.

What should practitioners be doing now to prepare for this change?

Practitioners should familiarise themselves with the materials and guidance provided by the LMA, the ARRC, the LSTA, ISDA and other trade bodies/regulators, and understand the concepts which underpin replacement benchmark calculations. Practitioners should also understand the impact for existing aircraft financings, and the related use of credit adjustment spreads. Aircraft financings are of course international in nature, and laws of multiple jurisdictions inevitably intervene. Local laws will vary as to the basis on which the transition away from LIBOR can be achieved and, by way of example, may impose registrations or filings with local aviation authorities or other registries.