FAQ: LIBOR transition and debt valuation
Strategic Account Management
Real Estate | Kennett Square, PA
Announcements made by the FCA, IBA, ISDA, and Bloomberg in 2021 stated that LIBOR’s final publication would occur on June 30, 2023. Loans indexed to LIBOR will transition to SOFR automatically following this date. In light of the announcement to discontinue LIBOR, many of our clients have inventoried their debt to understand how each loan will be impacted. While much focus has been spent on the mechanics around converting LIBOR debt to SOFR debt, less attention has been given to the valuation implications of this transition. This FAQ aggregates the top questions from our clients on the topic of debt valuation within the context of LIBOR transition.
How does the floating-rate index impact the valuation of my floating-rate loan?
The calculation of contractual interest for floating-rate loans contains two components: 1) interest associated with the reference index and 2) interest associated with the contractual loan spread.
The contractual spread is negotiated between a borrower and lender in advance of loan closing and is typically static for the term of the loan. Conversely, the index portion of interest in a loan (e.g., LIBOR, SOFR, etc.) will reset on a periodic basis throughout the life of the loan – most commonly resetting on a monthly or quarterly basis.
Chatham provides independent debt valuations following the methodology described in the paper, Debt valuation methodologies for financial reporting. As detailed in this methodology, the fair value of floating-rate instruments is primarily driven by the contractual spread of the loan relative to a market or replacement spread at the time of valuation. Therefore, the reference index does not impact the fair value of the loan because the interest rate associated with the reference index is consistently reset to market.
Will the transition of my LIBOR-based loan to SOFR result in mark-to-market fluctuations?
In March 2021, Bloomberg published spread adjustments to be used when transitioning away from an IBOR index. These spread adjustments were calculated based on the historical 5-year median spreads between the various IBOR indices and the new, alternative overnight Risk-Free Rate (RFR). In the case of 1-month LIBOR, the RFR would be 1-month SOFR, and the published spread adjustment between 1-month LIBOR to 1-month SOFR was set to 0.11448% (see example below). Additional details on specific spread adjustments and how these were established can be found in the IBOR Fallback Rate Adjustments Rule Book. As existing LIBOR loans convert to SOFR, a spread adjustment will be added to the reference index of the loan to account for the index transition. Following this approach, the above example of the interest expense for a floating-rate loan would transition to:
From a valuation perspective, a loan’s conversion to SOFR is not indicative of a change in the risk profile of the loan and therefore no changes would be made to the market spread of the loan due to a transition from LIBOR to SOFR. The spread adjustment is, instead, attached to the reference index. As a result, if the only revision to the loan is a typical or market standard transition to SOFR, there would be no mark-to-market changes attributable to the conversion of the loan from having a LIBOR index reference to a SOFR index reference as neither the contractual loan spread nor the market spread should change.
In some instances, borrowers negotiate with their lenders for separate and unrelated changes to their debt at the same time as they amend the loan to reference SOFR. Substantive changes to the terms of the loan may result in mark-to-market adjustments; however, this would be driven solely by changes made to loan terms unrelated to the LIBOR conversion.
When should I expect to see my debt transition away from LIBOR in my debt valuation reports from Chatham?
As of January 1, 2022, banks are no longer originating loans indexed to LIBOR. Existing debt that was originated against LIBOR and expected to remain outstanding past June 30, 2023 will transition away from LIBOR; however, the timing for this transition and the ultimate reference rate applied will depend on the terms captured within each floating-rate loan agreement.
Transition timing: The date upon which a given loan will transfer away from LIBOR will vary widely. This is because both lenders and borrowers are managing the transition process differently—some proactively amend loans while others anticipate allowing loans to transition away from LIBOR when the fallback language within their loans is triggered. The fallback language captured within loan documents can be categorized into several groups:
- Permanent Cessation: LIBOR is no longer being published.
- Pre-cessation Trigger: LIBOR may be published but is no longer representative as deemed by its regulatory supervisor.
- Unavailability of Tenor of Benchmark: LIBOR may be published, but a specific tenor may be unavailable (e.g., 1-month LIBOR is no longer available but 3-month LIBOR is).
- Early Opt-In: Upon specified events or upon the initiation of borrower and/or lender, a loan may transition away from LIBOR.
- Silent: No fallback language is listed in the loan documents.
Intercontinental Exchange (ICE) Benchmark Administration (IBA) has stated it will publish 1-month, 3-month, 6-month, and 12-month LIBOR through June 30, 2023, after which the rates are expected to be deemed non-representative. To determine whether a loan will transition away from LIBOR before this date, a borrower should review the fallback language in each floating-rate loan since there are fallback mechanisms that may result in an early transition (e.g., Early Opt-In). Most loans that do not transition prior to June 30, 2023 are expected to transition to a new reference rate no later than this date. Because the LIBOR cessation date has been set well into the future, borrowers are able to plan for the orderly transition of their loans from LIBOR. Once a loan has transitioned away from LIBOR, a borrower should contact Chatham to communicate this event has taken place, and Chatham will amend the loan within our system and models to reflect the new RFR.
Reference rate: The Alternative Reference Rates Committee (ARRC) has recommended SOFR to serve as the replacement for LIBOR. Because of this, most fallback language within loan agreements will ultimately result in a loan referencing SOFR once LIBOR is no longer available. There are, however, some loan agreements that reference alternative interest rates. As some rates could be materially different than SOFR as of the time of this publication, fallback to alterative reference rates could be disadvantageous and Chatham recommends that clients proactively renegotiate with lenders to amend such loans to utilize more borrower friendly fallback language. If you have questions on the fallback language captured within your floating-rate loans, Chatham can assist with inventorying the fallback language in your floating-rate portfolio and recommending loans that should be amended to insert market fallback language that would result in a smooth transition to SOFR.
Please see a previous post, "FAQ: USD LIBOR transition to SOFR", for additional considerations and detail on LIBOR fallback timing and alternative reference rates.
Is there action needed on my part to ensure the transition from LIBOR does not impact my valuation reporting process?
Due to the variable timing under which a loan can transition from LIBOR, clients are encouraged to proactively determine the expected transition plan for floating-rate loans expected to remain outstanding beyond June 30, 2023. Chatham can assist with this determination and perform an audit of your floating-rate loans to classify the expected transition given a loan’s specific fallback language. To ensure your valuation reporting process remains uninterrupted throughout this LIBOR transition phase, please promptly share any updates with respect to loans where LIBOR transition has been initiated.
Have questions about LIBOR transition or debt valuation?
Get in touch with our Valuation team
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Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0093
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