Five new LIBOR questions your organization must answer before June 30

1. Should we proactively amend our derivatives or wait to fall back?

Your organization can choose to proactively amend its LIBOR derivatives to a SOFR rate setting to match their underlying cash product or let them fall back to SOFR compounded in arrears (Daily SOFR). We have experienced many corporations proactively amending their LIBOR derivatives to Term SOFR.

Proactively amending the derivatives to Term SOFR will provide index alignment with debt transitioning to Term SOFR, which is most commonly the preferred fallback rate in floating rate debt. While banks charge a Term SOFR premium to trade on this index, this is the only way to ensure the economics and accounting for the hedges are in lockstep.

While choosing to fall back to Daily SOFR may be more straightforward and economically attractive, doing so will introduce an economic mismatch between the debt and derivative. This economic mismatch will present hedge accounting challenges and require additional testing to maintain hedge accounting for companies under both the qualitative “shortcut” assessment approach, and the quantitative “long haul” regression method.

2. How long do I have to proactively amend these transactions?

While June 30, 2023 is the final date LIBOR will be published, some banks have indicated that they will not be able to support any new amendments after June 1 due to trade volume issues. Given the operational constraints for many banks during the month of June, companies who want to proactively amend their trades should put together an action plan to do so before late May.

3. If an economic mismatch exists, what are the audit firms requiring?

Based on guidance from major audit firms, this economic mismatch would require companies applying the shortcut approach to transition to long haul. For those under long haul, in addition to quantitative testing, companies are required to do a supplemental test to show a correlation between fixings of term SOFR vs. daily compound SOFR.

4. Is it possible to use a derivative to hedge a pool of debt?

Companies with “you pick 'em” debt can select different tenors of SOFR (1m, 3m, etc.) at the start of each period. These organizations often want the flexibility to switch back and forth between tenors based on rate settings or cash needs. Accordingly, accounting teams want their hedge designation memos to include the flexibility to switch back and forth between different SOFR tenors while maintaining hedge accounting. While views on this type of broad SOFR designation strategy are still evolving, the consensus among major audit firms is that this may result in a de-designation event and a potential missed forecast if not originally documented and tested.

5. What do I need to do now?

Whether you decide to proactively amend your derivatives or elect to fall back, it is important to finalize an action plan as soon as possible. Once you have alignment internally, socialize this plan with your auditors to ensure the accounting will work. Given the nuanced requirements for effectiveness testing and the additional supplementary test required in the event of a mismatch, you should also ensure your system is equipped to handle the accounting approach going forward.

The bottom line

As you evaluate whether you will proactively amend your debt and interest rate hedges or fall back, it is important to understand the evolving set of implications of each alternative for your organization. Throughout the transition, Chatham has partnered with companies of all sizes, providing impactful solutions across economics, accounting, and operations.

Economics

Having already proactively amended over $8 billion in SOFR interest rate derivatives, Chatham has the market insights and industry expertise to negotiate Term SOFR bank charges on your behalf. With many banks unable to handle proactive amendments after June 1, Chatham is equipped to help you understand the economic outcomes available for your organization and quickly negotiate any necessary amendments.

Accounting

As auditor guidance on broad SOFR designations and requirements for effectiveness and supplemental testing continues to evolve, you may have more questions than answers. Chatham’s deep bench of hedge accounting advisors will partner with you and your audit team to understand the requirements for your organization to maintain preferred accounting treatment.

Operations

To support the operational lift required by robust hedge accounting approaches, our ChathamDirect SaaS platform can automate the regression and correlation effectiveness testing required by auditors, minimizing the manual burden for you and your team.