What to Watch for as LIBOR Fades Into History
Businesses mired down by the impacts of COVID-19 are facing enough difficulties. But the march to LIBOR’s end has continued unabated.
Governing bodies across the globe have made it clear that LIBOR will not extend beyond 2021. To date, we have seen very little movement away from LIBOR. Yes, big agencies and financial institutions have made some movement away from LIBOR. But most corporations and other financial institutions are still in the planning stages. And with everything going on in the world right now, it has become even more difficult to plan and take action.
Here’s what we are seeing:
- LIBOR is certain to be replaced by 2022
- The debt market has changed significantly for recent borrowers
- The SOFR market continues to mature
- LIBOR contract references on new contracts set to end in mid-June 2021
CME plans to start discounting exchange-traded derivatives with SOFR starting in mid-October. Currently, these interest rate swaps are discounted using the OIS (Fed Funds curve). Migrating to SOFR discount curves is the next step in developing SOFR as the LIBOR replacement reference rate.
Hedge Trackers has been tracking the shift in the debt market in recent months.
As interest rates have reached record low levels, the value of minimum interest rate provisions in credit facilities has increased. The minimums are designed to protect lenders from negative rates and the need to pay borrowers. The increase in value has caused some hiccups with hedge accounting. If you have debt with a floor of 0% hedged by swaps without a similar minimum interest rate, you should take a close look at your effectiveness assessments.
At the beginning of the year, most new debt issuances and refinancings included a minimum interest rate of 0%. Since the crisis hit in March, these interest rate minimums have been increasing and .75% and even 1.0% are not uncommon which has made hedge accounting without corresponding minimums very difficult if not impossible.
If you need help with your effectiveness assessments in this changing market place, we have a team of people trained in the intricacies of testing.
The SEC has encouraged companies to disclose the expected impact of reference rate reform (RRR). Together with reporting on the impact of COVID, more and more companies are disclosing the expected impacts of reference rate reform in their 10-Qs and 10-Ks. In March this year, FASB approved Topic 848. This guidance lays out the optional expedients, almost universally beneficial, available to assist with the numerous accounting rules related to RRR.
Start preparing for the shift by capturing and disclosing the expected impact of RRR on your financial statements: economic and accounting impacts. Need help? Our team is ready to assist clients in crafting rate reform disclosures.
The Alternative Reference Rate Committee (ARCC) published a timeline of milestones to guide the reform. They have also published a practical implementation checklist that many are finding handy.
By the end of Q3 this year, the ARCC expects business loans to incorporate hardwired fallbacks into contracts. This is critical to stop dramatic and unexpected increases in borrowing rates from the unattractive fallback language that has traditionally been buried in loan documents. The target to stop referencing LIBOR in new contracts is set for June 30, 2021.
The International Swaps and Derivatives Association (ISDA) plans to publish amendments to the ISDA 2006 Definitions. The ARCC has set a target for derivatives to have hardwired fallbacks incorporated no later than four months after ISDA releases the updated definitions. They have also set a target date to stop referencing LIBOR in new derivative contracts by June 30, 2021.
In summary, continue to plan for LIBOR’s end.
If you have older credit facilities (and even some newer ones), review and renegotiate any unattractive fallback provisions in your borrowing agreements, and stay on top of the transition. Otherwise, you will likely end up paying a punitive rate during the transition period.
And even if you don’t have direct LIBOR exposures, you should still expect to see some impact from the transition.
The forward point curve will be impacted by the IBOR curves and curve change timing of both currencies. So, foreign currency derivatives (such as forwards, swaps and options) may see increased volatility. The credit rate spreads used in derivative and other valuation models currently represent spreads over LIBOR. As the markets adjust the underlying rate environment, the credit spreads will adjust to represent the appropriate (and presumably unchanged) discounting for credit.
To discover how LIBOR may be impacting your existing contracts, please contact us.