The transition away from the London Interbank Offered Rate (LIBOR) is rapidly approaching. While most market participants are focused on June 2023, which is when the most widely used USD LIBOR tenor settings will no longer be published, the next several months are expected to yield transformative funding and hedging outcomes for clients. Federal regulators have instructed all supervised financial institutions to stop issuing new LIBOR loans and executing LIBOR referenced interest rate contracts by December 31, 2021. For existing debt and swap contracts, we encourage all clients to take inventory of benchmark indices and to determine whether existing documentation adequately addresses LIBOR replacement fallback provisions. For new funding and hedging considerations, and for existing contracts without LIBOR replacement fallback provisions, we encourage clients to reach out to PNC. Together, we can discuss alternative indices that are available and their impact to capital structures and risks.
Currently, the most prevalent alternative indices are summarized below:
- The Bloomberg Short-Term Bank Yield Index (BSBY) is based on transaction-related data, including actual executed transactions and firm executable quotes. It does not rely on subjective inputs in its calculation. Similar to LIBOR, BSBY is a credit-sensitive rate, has a term structure, and is hedgeable.
- The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. SOFR is a risk-free rate. SOFR can be structured as both an overnight rate and a term rate. Currently, overnight SOFR is hedgeable. PNC anticipates that term SOFR will be hedgeable, subject to certain limitations, by the end of 2021.
Other indices, such as SIFMA and EFFR, described below, are less commonly utilized:
- The Securities Industry & Financial Markets Association Municipal Swap Index Yield (SIFMA) is a seven-day, high-grade market index composed of certain tax-exempt variable rate demand obligations’ (VRDOs) reset rates that meet the criteria established by the Securities Industry & Financial Markets Association and that are reported to the Municipal Securities Rule Making Board. The index is a tax-exempt index, is published weekly, and is hedgeable.
- The Effective Federal Funds Rate (EFFR) is a volume-weighted median of overnight federal funds transactions. The federal funds market consists of domestic unsecured borrowings in U.S. dollars by depository institutions from other depository institutions/entities. EFFR is set daily and is hedgeable.
While USD LIBOR cessation may appear to be out on the horizon, fundamental changes have already begun for both credit and derivative providers given the pronouncement by regulators that supervised institutions should stop making new LIBOR loans of all kinds by the end of this calendar year. Regulators have announced that they will scrutinize supervised institutions closely on their compliance with transition requirements, and failure to comply could result in regulatory action. If you plan to seek new lending or hedging facilities, know that going forward, term sheets will include alternative indices, and likely will not include a LIBOR alternative. Given that the market continues to consider alternative rate indices, there may not be consistency among terms each credit or derivative provider is willing to offer. Because of multiple alternatives, some credit or derivative providers may gravitate towards one alternative index versus another as a primary benchmark for lending or derivatives. It is not possible to state with certainty which alternative indices will be widely adopted. By understanding each one, your institution can identify the most appropriate index for your funding and hedging needs. Amidst this environment, PNC Healthcare is committed to continuing to meet our clients’ needs.
As noted in our opening paragraph, it is important for clients to inventory all the index exposures in their capital structures as well as any LIBOR replacement fallback provisions already included in their existing contracts. Furthermore, PNC Healthcare encourages clients to understand the impact each alternative index may have within their capital structures from both a cash flow and valuation perspective. For example, consider the following two borrowers:
Alternative Indices - Client Scenarios*
|Borrower A||Borrower B|
|% of Total
|% of Total
|Fixed Rate||N/A||$ 100.0||40.0%||Fixed Rate||N/A||$ 100.0||40.0%|
|VRDO||SIFMA (proxy)||50.0||20.0%||VRDO||SIFMA (proxy)||50.0||20.0%|
|DPB||% of LIBOR||50.0||20.0%||DPB||% of LIBOR||50.0||20.0%|
|Term Loan||LIBOR||50.0||20.0%||Term Loan||LIBOR||50.0||20.0%|
|Total Par Amount||$ 250.0||Total Par Amount||$ 250.0|
|Fixed Pay (rec SIFMA)||N/A||$ 50.0||20.0%||Fixed Receive||SIFMA||$ 50.0||20.0%|
|Fixed Pay (rec LIBOR)||N/A||50.0||20.0%||Fixed Pay (rec LIBOR)||N/A||$ 50.0||20.0%|
|Total Notional||$ 200.0||Total Notional||$ 200.0|
|Net Exposure Summary||Net Exposure Summary|
|Pro Forma Exposure Summary||Pro Forma Exposure Summary|
*This example is for illustrative purposes only.
As referenced above, Borrower A has net exposure to SIFMA (Basis Swap) that is equivalent to 40% of their outstanding debt and net exposure to LIBOR (Term Loan) that is equivalent to 20% of their outstanding debt. Since the VRDO and Direct Purchase Bond (DPB) are hedged with a SIFMA and LIBOR-indexed fixed-pay swap, respectively, we are considering net exposure on these two instruments to be zero. The Borrower has a good understanding of SIFMA’s market dynamics and is comfortable with the index. What is the impact of replacing LIBOR with SIFMA on the DPB for Borrower A? SIFMA exposure increases to 60% of outstanding debt. Furthermore, Borrower A has also decided to diversify their index exposure and replace the index on the term loan with BSBY; thus, pro forma exposure to BSBY is 20% of the capital structure.
Borrower B has net exposure to SIFMA (VRDO, SIFMA Fixed Receive Swap, and Basis) that is equivalent to 80% of their outstanding debt and net exposure to LIBOR (Term Loan) that is equivalent to 20% of their outstanding debt. Borrower B has taken on meaningful tax risk relative to its debt and has experienced lower interest cost historically. Borrower B has determined that it does not want to increase its exposure to SIFMA and has elected to replace the index on its DPB and the term loan with BSBY, thereby increasing its BSBY index exposure to 40% of its capital structure.
In addition to exposure considerations, clients should also evaluate their basis risk profile and the impact of alternative indices. Basis risk occurs when there is a mismatch between the hedged instrument (e.g., debt) and the hedging instrument (e.g., the swap). Basis risk can be caused by many different factors, such as different indices, rate-setting mechanism, day-count convention, frequency of rate setting, forward-looking versus backward-looking rates, etc. Further, clients should also assess the risk that a particular alternative index may not be widely adopted, which could impact liquidity.
Impact of ISDA LIBOR Cessation Fallback Protocol
If we focus on Borrower A, consider the following additional assumption (not represented in the table above but for illustrative purposes): Borrower A has elected to adhere to the International Swaps and Derivatives Association’s (ISDA) protocols for LIBOR fallback, which means that the LIBOR component in both the fixed-pay swap (pay fixed/receive LIBOR) and the basis swap (pay SIFMA/receive % of LIBOR) would fall back to SOFR (compounded in arrears) + the published spread adjustment.
Remember that Borrower A has bilaterally negotiated with the credit provider on the term loan (interest rate risk is hedged with the fixed-pay swap) and the alternative index agreed upon is SIFMA (daily simple).
Borrower A has previously been comfortable with basis risk in the form of the basis swap (pay SIFMA/receive % of LIBOR). In the assumptions as described above, the basis swap relationship is now pay SIFMA/receive % of SOFR. This structure is duplicated in the hedging relationship between the SOFR-indexed fixed-pay swap and the DPB, representing 60% of Borrower A’s capital structure.
Consider an alternative scenario on the DPB replacement index: Borrower A has now bilaterally negotiated with its credit provider on the term loan (interest rate risk is hedged with the fixed-pay swap) and the alternative index agreed upon is Daily Simple SOFR. While the hedged and hedging instrument are now both indexed to SOFR, the actual rates may still differ if there is a mismatch in how SOFR is calculated under the loan and the swap (Daily Simple vs. Compounded in Arrears). Further, the basis swap relationship has also changed given the replacement of % of LIBOR with SOFR.
For borrowers who have elected hedge accounting treatment, the replacement index rate(s) selected may impact whether hedge accounting treatment can be maintained. Replacement index rate(s) may also impact swaps/underlying debt that have been integrated for tax purposes.
Clients are strongly encouraged to consult with their own independent advisors to assess alternative indices and determine whether an applicable alternative index is appropriate for them and will meet their hedging, tax and accounting objectives.
PNC Healthcare stands ready to assist our clients during the LIBOR transition process and are available to answer any questions that our clients may have during the transition period.