disappearance of LIBOR: overview of possible basis risk for swapped variable rate loans | Bass, Berry & Sims PLC
Base risk of variable rate loans
In connection with the likely termination of LIBOR as a viable index at or before the end of 2021, any borrower with variable rate loans based on LIBOR that has hedged, or plans to hedge, the variable rate exposure on these loans by entering into interest rate agreements the swaps should be aware of the potential “basis risk”. Basis risk is the potential mismatch between the variable rate paid by the borrower on the hedged loan and the variable rate received by the borrower on the corresponding swap.
Variable rate loan documents
Almost all loan documents with variable rate loans include “fallback” provisions specifying how the variable rate will be determined once LIBOR is no longer available and cited as a viable variable rate index. Amendments to credit agreements being implemented are likely to include updates to these LIBOR fallback provisions, with a variable rate based on Secure overnight funding rate (SOFR) as the probable basis of the new variable rate index.
Post-LIBOR interest rate swaps
The obligations of a borrower under an interest rate swap are governed by a separate framework agreement of the International Swaps and Derivatives Association (ISDA) (and some built-in ISDA definitions) rather than by loan covered. The ISDA Master Agreement also includes fallback provisions that will become applicable once LIBOR is no longer listed as a viable index. As currently drafted, ISDA’s fallback arrangements will not be satisfactory to address the continued unavailability of LIBOR, but ISDA is expected to issue amended definitions in July 2020 that specify an alternative floating rate index. more feasible, which will also be based on SOFR. The new ISDA fallback provision will automatically apply to swaps entered into after the expected effective date of September 2021 and ISDA will provide a simplified method for borrowers and swap providers to agree to apply the new provisions. ISDA fallback to existing interest rate swaps entered into before this effective date. Dated.
Potential disconnect between loan and swaps
While the loan and swap alternatives are likely SOFR-based, there could be significant differences in how the final amount payable is determined. For example, there could be variations in the following provisions between the fallback provisions of the loan and the swap that potentially expose a borrower to basis risk:
- Timing of LIBOR unavailability arrangements.
- Whether SOFR is early or late.
- How SOFR is converted from an overnight rate to a forward rate that matches the previous LIBOR period.
- The additional spread to account for SOFR status as a “risk-free” rate based on overnight Treasury rates.
While any difference between the loan and the ISDA fallback rates may be small enough that they are not a financial problem, these differences could potentially affect how a borrower accounts for hedge for GAAP and tax purposes.
Suggested approach for processing variable rate loans
Before changing the relief provisions in the loan documents for exchanged debt or entering into new interest rate swap agreements, borrowers should seek assistance in analyzing how these relief provisions fit together and the potential implications of any mismatch.