Executive summary
Beginning January 1, banks are no longer permitted to enter into agreements to provide loans that accrue interest based on the London Interbank Offered Rate (commonly known as LIBOR), meaning 2022 will be the year that companies start to learn to manage debt in a post-LIBOR world (note: existing loan agreements can continue to provide LIBOR-based loans until June of 2023). It is not yet clear how smooth the transition will be, but directors, financial officers and treasury teams should be prepared for the following issues.
Borrowing costs may appear to increase
The most likely replacement rate for LIBOR is the Secured Overnight Financing Rate, or SOFR. Unlike LIBOR, SOFR is a secured rate and has no built-in term risk component. This means SOFR is a lower rate than LIBOR. The pricing on existing loans will maintain the current economics between borrowers and lenders by adjusting SOFR; new loans that are based on SOFR may require higher margins to account for this difference (even if a borrower’s actual credit profile is unchanged). If this happens, companies may need to explain to their shareholders why it appears that their cost of borrowing has increased.
Companies may be able to lock in a slightly lower rate
Adding an “adjustment” to SOFR is supposed to make existing loans economically equivalent to LIBOR, but the debt market has not yet settled on the appropriate amount for that adjustment. Because of historically low interest rates, the difference between LIBOR and SOFR for a one-month interest period is less than five basis points, while the five-year average between the two rates is nearly 12 basis points. As long as there is no market-standard adjustment, companies have scope to try to negotiate a lower adjustment and lock in a lower risk-free rate on existing LIBOR-based debt.
Senior leaders may have less visibility on their company’s future interest expense
Until the market settles on how SOFR-based interest will be calculated, corporate treasury teams may find it challenging to calculate future interest payments until the end of a fiscal month or fiscal quarter. Most banks have not yet confirmed that they are prepared to calculate interest based on term SOFR (as opposed to daily SOFR), which would permit companies to calculate the interest due at the end of a monthly or quarterly interest period as they currently do for LIBOR. Companies that borrow from banks that do not use term SOFR will calculate interest daily and cannot calculate their interest payment with certainty until within a week or so of an interest payment date. This is also an issue for hedging interest rate risk -- swaps might be an effective hedge but will not be a perfect hedge. Companies need to be prepared to keep some extra cash available for unexpected interest payments until the market has adjusted to a post-LIBOR world.
Key takeaways for boards
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Companies’ cost of borrowing may appear to increase, and companies should notify key stakeholders (shareholders, other lenders and credit rating agencies) of this possibility early if the business will be raising debt financing this year.
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It may be possible to lock in a slightly lower rate, so companies’ treasury teams should engage with their lender banks to plan for this transition and discuss the appropriate adjustment – even if the company is not refinancing in the near term.
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Senior leaders may have less visibility on the company’s future interest expense – boards may want to note this in budgets and forecasts for this fiscal year and next until the company’s treasury team is comfortable with the new reference rate.