The widely used London Interbank Offered Rate (LIBOR) will be discontinued in 2021 and replaced with a new benchmark, expected to be the Secured Overnight Financing Rate (SOFR) for U.S. dollar transactions. In 2018, we saw what appeared to be significant steps in the transition to SOFR: the New York Federal Reserve began publishing daily rates, the International Swaps and Derivatives Association (ISDA) published its SOFR definition, and market participants began trading in bilateral, uncleared OIS that reference SOFR.
The market-wide transition from LIBOR to SOFR will affect issuers in both their existing LIBOR-based debt (bonds, loans) and LIBOR-based derivative contracts (swaps, caps). In addition, if LIBOR is a component of any existing or anticipated debt that extends past 2021, swaps, or both, there is risk exposure connected with the transition to SOFR. There are significant differences between SOFR and LIBOR which issuers will need to consider when preparing for the transition.
DIFFERENCES BETWEEN LIBOR AND SOFR
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SOFR tracks closely with the effective fed funds rate and reasonably well with 1- and 3-month LIBOR. SOFR trades below LIBOR because it is an overnight rate and represents collateralized transactions.
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CONSIDERATIONS FOR EXISTING AGREEMENTS
Issuers may consider taking pre-emptive steps now to begin addressing the effects of the pending transition on existing agreements. Steps and considerations may include:
- Review LIBOR references and potential replacement language
- Consider the adjustments necessary to compensate for receiving a lower floating rate
- Consider bilateral negotiation with counterparties and creditors to identify an economically neutral result under the new standardized method
- Consider tax and accounting implications, such as potential triggers for reissuance of debt, and hedge effectiveness1
MODIFICATIONS OF EXISTING SWAP AGREEMENTS
An issuer or borrower may determine that it is in its best interest to proactively eliminate or reduce “LIBOR index” risk by modifying agreements prior to any LIBOR discontinuation event. Several index alternatives exist, including SIFMA and fed funds, with each strategy carrying its own benefits and considerations.
- SIFMA Index Conversion: Issuers can modify existing swap agreements with an index conversion to SIFMA in order to mitigate LIBOR discontinuation risk in the future. SIFMA has a high correlation with weekly floating debt resets.
- Fed Funds Index Conversion: Represents another alternative to mitigate LIBOR discontinuation risk. Fed Funds has historically tracked closely to SOFR. Issuers would maintain the ability to subsequently convert to SOFR or another replacement index in the future based on market conditions selected by the issuer.
Issuers and Investors can find out more about the effects related to any of your LIBOR transactions, and can take steps now to prepare for these changes by contacting HilltopSecurities’ Structured Products Group.
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1Please consult with your legal and tax professional(s).