June 23, 2021 - by Meredith Coffey. What rates really will replace LIBOR…and can you hedge them? These are among the questions bedeviling lenders. At the GFMI Conference on Monday, we tackled these issues …and we recap them below. Full presentation can be found here.
As Slide 4 of the presentation demonstrates, there are a number of potential replacement rates, but they broadly break down into some form of SOFR (a risk-free overnight rate based on Treasury repos) or Credit Sensitive Rates (CSRs, or rates calculated based on bank funding components like bank deposits, CD, CP and bank bonds).
But which rate to pick? Parties must determine what they are looking for in a replacement rate: Do they need a rate that is “known in advance of the interest period?” Do they also need credit sensitivity? How critical is the ability to hedge perfectly vs effectively? Let’s break this down.
First, as captured in Slide 6, most parties say they want a rate that is “known in advance” of the interest period. Such a rate would operationalize similarly to LIBOR, it would allow the borrower to know its cash flows in advance, it would be easy to floor and it would work nicely with CLOs’ interest coverage tests. Forward Looking Term SOFR (which should be available for loans by late summer), SOFR Compounded in Advance and CSRs generally all pass the “known in advance” test.
But if a party also wants a rate that acts like LIBOR in periods of disruption like the financial crisis or the Covid-19 crisis, then a CSR might fit better (see Slide 5). A CSR rises in a market disruption and may reduce borrowers’ desire to opportunistically draw down in periods of disruption. While the banking regulators are lukewarm about CSRs (at least for derivatives and capital markets products), they acknowledge that CSRs may have a role in traditional bank lending – assuming that the parties really understand the rates and underlying data.
But what about hedgeability? Here – as demonstrated on Slide 7 – the world gets more complex. The most liquid hedging scenario (#2) is one where the loan uses Daily Simple/Compounded SOFR or SOFR Compounded in Advance. These rates likely allow the borrower to approach a perfect hedge. However, the Daily SOFR rates are not known in advance of the interest period (something borrowers strongly desire), while banks tend to be less enthused about offering a (potentially stale) SOFR Compounded in Advance rate on a loan.
If the borrower absolutely, positively must know its rate in advance of the interest period, then scenario #1 shows that it can use SOFR Compounded in Advance (which banks are less excited about) or a CSR (which currently isn’t as liquid as hedging a SOFR loan).
If a borrower absolutely wants a forward looking term rate (scenario #3), a CSR or Term SOFR comprise the solution set. CSRs can be hedged, though that market may be nascent; however, at this time there are restrictions on the use of Term SOFR in derivatives.
At the end of the day, the presentation demonstrates that there is no perfect replacement rate to LIBOR. But we would remind readers that LIBOR itself was far from perfect.