ISDA’s IBOR Fallbacks Supplement and Protocol for U.S. CRE investors
- October 23, 2020
Hedging and Capital Markets
Real Estate | Kennett Square, PA
SummaryOn Friday, October 23, the International Swaps and Derivatives Association (ISDA) launched the IBOR Fallbacks Supplement and Protocol, which provides a framework for transitioning interest rate derivatives from USD LIBOR to SOFR.
- Existing LIBOR interest rate caps and swaps do not contain fallback language well suited for a permanent cessation of LIBOR or determination that LIBOR is no longer representative, which will likely occur by the end of 2021.
- The ISDA IBOR Fallbacks Supplement provides a revised framework for LIBOR discontinuation in these trades, outlining a mechanism by which LIBOR-indexed trades can convert to a replacement reference rate based on SOFR.
- The ISDA IBOR Fallbacks Protocol provides a streamlined means to incorporate the terms of the Supplement to pre-existing LIBOR caps and swaps, though CRE borrowers may also do so via bilateral amendments.
- While incorporating these terms will ensure continued functioning of LIBOR caps and swaps beyond 2021, these terms may not perfectly match conventions used by lenders in underlying loans.
- The decision to incorporate the Supplement should be driven by the degree to which the cap or swap needs to match the underlying loan exactly, and an understanding of the consequences if it does not.
On Friday, October 23, the ISDA formally launched the IBOR Fallbacks Supplement and Fallbacks Protocol. Together, these documents provide a framework for LIBOR-indexed derivatives to transition into SOFR-indexed derivatives in conjunction with the broader market move from LIBOR to SOFR. This includes the interest rate caps and interest rate swaps that commercial real estate (CRE) investors frequently employ when managing exposure to rising interest rates in conjunction with their floating-rate debt. With the launch of these documents and the increasing probability that LIBOR is either discontinued or is declared unrepresentative sometime in 2021, we expect that CRE investors may hear from their derivative providers about incorporating these terms into existing trades. The purpose of this FAQ is to provide an overview of these documents and outline the potential business considerations for using them. For a more general overview of the LIBOR transition, please reference:
Supplement and Protocol basics
- What are the ISDA IBOR Fallbacks Supplement and Fallbacks Protocol and why are they necessary?
- What are the key business provisions of the ISDA IBOR Fallbacks Supplement?
- How will these business provisions work in practice?
Documentation adoption of the ISDA IBOR Fallbacks Supplement
- How will the terms of the Supplement be applied to pre-existing caps and swaps?
- Should I expect my cap/swap provider to ask me to incorporate the Supplement into my pre-existing cap or swap?
- What happens if I do not incorporate the Supplement into my pre-existing LIBOR cap or swap?
Business impact of implementing the ISDA IBOR Fallbacks Supplement/Protocol
- Should I elect to incorporate the Supplement into my pre-existing LIBOR caps or swap?
- Mismatches in fallback language between the Supplement and my loan agreement are a big consideration. How does the typical floating-rate loan handle LIBOR replacement?
- Will the changeover from LIBOR to SOFR impact the value of my cap or swap?
- I have a lender-required interest rate cap. Are there any considerations for this situation?
- I have a loan that has a fixed rate via an interest rate swap. Are there any considerations for this situation?
- I placed a forward starting swap to hedge a fixed-rate bond or loan issuance. Are there any considerations for this situation?
- I designate my caps and swaps as hedges under GAAP/IFRS. How will a conversion of a pre-existing cap or swap from LIBOR to SOFR impact my hedge designation?
- Once my cap/swap transitions to SOFR, what happens if SOFR ceases to be published?
- Are there tax consequences associated with incorporating the Supplement's provisions into my cap or swap?
Supplement and Protocol basics
What are the ISDA IBOR Fallbacks Supplement and Fallbacks Protocol and why are they necessary?
The Supplement is a series of updated provisions and definitions that provide a contractual framework for handling the transition of LIBOR to SOFR, as well as the transition of other “IBORs” to alternative risk-free rates (RFRs). When incorporated into a derivative like a cap or a swap, they define:
- The events, or “triggers” that cause that derivative to convert from LIBOR to SOFR
- The precise SOFR rate (the “replacement index”) which will replace LIBOR in that contract
- The adjustment to be made to the trade economics (the “spread adjustment”) to account for the historical difference between LIBOR and SOFR
The Protocol is a contractual amendment mechanism that allows parties to incorporate the provisions of the Supplement into a pre-existing derivative. While the Supplement will apply automatically to any new cap or swap executed after the Supplement becomes effective on January 25, 2021, the Protocol is used to incorporate the Supplement provisions to any pre-existing cap or swap.
The Supplement and Protocol are necessary because the existing language for LIBOR unavailability in caps and swaps is problematic for a permanent cessation of LIBOR. This language requires the hedge provider to obtain quotes from other banks on their cost of funds, something which would be administratively challenging to do if LIBOR were discontinued on a permanent basis. (Back to top)
What are the key business provisions of the ISDA IBOR Fallbacks Supplement?
The Supplement has three key business provisions that provide for a transition from LIBOR to SOFR in a cap or a swap. For this piece, we are focusing on 1-month LIBOR, which is the most common index for floating-rate CRE loans and their associated caps and swaps.
- Term-adjusted SOFR reference rate: This is the basis of the rate that will replace LIBOR in the cap or swap. Under the Supplement, 1-month LIBOR will be replaced by a 30-day average SOFR rate calculated and published by Bloomberg under the ticker SOFR1M. This rate will match closely with the 30-day average SOFR rate published by the New York Federal Reserve, which can be found on Chatham’s website. The Supplement provides that this rate will set in arrears, near the end of the interest period, not at the beginning as is most common for 1-month LIBOR caps and swaps.
- Spread adjustment: As a secured overnight rate, SOFR has historically been lower than LIBOR, a unsecured term rate. To preserve the economics of the cap or swap, the Supplement provides for the addition of a spread adjustment to the SOFR1M rate. In the case of a cap or swap on 1-month LIBOR, the spread adjustment would be the 5-year historical median difference between 1-month LIBOR and the 30-day average SOFR, calculated and published by Bloomberg under the ticker SUS0001M. Currently, this spread adjustment is ~11 basis points. Under the Supplement, the replacement rate (also known as Fallback Rate SOFR) for 1-month LIBOR is the sum of the 30-day average SOFR rate (SOFR1M) and the spread adjustment (SUS0001M). This replacement rate is published on Bloomberg under the ticker FUS0001M.
- Trigger events: The trigger events describe the conditions under which the conversion of the cap or swap from LIBOR to SOFR would occur. For 1-month LIBOR, the triggers are one of the following:
- A public statement or other publication by the administrator of LIBOR that it has ceased or will cease to provide LIBOR permanently or indefinitely
- A public statement or other publication by the regulatory supervisor of the administrator of LIBOR or by the Federal Reserve that the administrator of LIBOR has ceased or will cease to provide LIBOR permanently or indefinitely
- A public statement or other publication by the regulatory supervisor of the administrator of LIBOR that LIBOR is no longer or at a specified future date no longer will be representative of the underlying market and economic reality for which it is intended
The first two of these triggers are known as “cessation triggers”; they apply when LIBOR ceases to be reported or when it is announced that LIBOR will cease to be reported. The latter of the three triggers is known as a “pre-cessation trigger”; it may apply even if LIBOR continues to be published. It is also important to note that each of these triggers contemplate a situation in which an announcement that LIBOR will be discontinued can occur in advance of the actual discontinuation of LIBOR itself. (Back to top)
How will these business provisions work in practice?
It’s important to recognize that there are two key dates that drive the application of these terms: the announcement date (the date when it is announced that LIBOR will be discontinued or no longer representative) and the actual LIBOR cessation date (the date beyond which LIBOR will no longer be published or no longer be representative). These need not be the same date and, in fact, current expectation is that the UK Financial Conduct Authority (the FCA, the regulator of LIBOR) may announce before the end of 2020 that LIBOR will no longer be representative beyond the end of 2021.
With this in mind, let’s walk through an example of how a transition would work on an interest rate cap. We’ll assume that on December 1, 2020 (the announcement date) the FCA announces that, as of January 1, 2022 (the LIBOR cessation date), LIBOR will no longer be representative. We’ll assume that the interest rate cap is on a loan amount of $25M, has a strike rate on 1-month LIBOR of 1%, and matures on January 1, 2023.
On the announcement date of December 1, 2020, nothing happens to the interest rate cap. What does happen is determination of the spread adjustment defined above, using the 5-year median difference between 1-month LIBOR and the 30-day average SOFR rate. For this example, let’s assume that the spread adjustment is 11 basis points, or 0.11%.
Between December 1, 2020 and January 1, 2022, the cap continues to act as a cap on 1-month LIBOR — it pays out to the owner of the cap if 1-month LIBOR exceeds 1%. On January 1, 2022, it changes over to a cap on 30-day average SOFR, subject to the 11-basis-point spread adjustment. At that point and through the cap maturity of January 1, 2023, if 30-day average SOFR plus 11 basis points exceeds the 1% strike of the cap, the cap will pay out to its purchaser.
There is one other detail worth mentioning. The majority of caps (and swaps) on CRE loans are structured so that LIBOR is observed two business days prior to the first day of the interest period. This ensures that they line up with the underlying loans, which typically observe the same convention. The terms of the Supplement differ in this respect. When the cap transitions from LIBOR to SOFR, the observation date for the rate changes from at or before the start of the interest period to two business days prior to the end of the interest period — the rate is no longer known at the start of the interest period but rather two business days prior to the end. This creates the risk of a mismatch with the underlying loan depending on how the loan itself transitions from LIBOR to SOFR. The borrower may end up with a loan that resets at the start of the period, but a cap that resets at the end of the period. This potential mismatch is one of the reasons we believe incorporating the Supplement into a cap or swap should not be done without first reviewing and understanding the fallback language in the underlying loan. (Back to top)
Documentation adoption of the ISDA IBOR Fallbacks Supplement
How will the terms of the Supplement be applied to pre-existing caps and swaps?
New caps and swaps, transacted after January 25, 2021, will automatically incorporate the terms of the Supplement; it will be standard in their documentation from this point forward. Caps and swaps put in place prior to this date will need to be amended to incorporate the Supplement. There are several ways this may be done.
The ISDA Fallbacks Protocol is one which we expect many market participants to use. Accessible via ISDA’s website, the Protocol provides a streamlined mechanism for incorporating the terms of the Supplement. A CRE borrower using this approach would provide certain administrative information via the ISDA website and would be provided an adherence letter for signature. After uploading the signed adherence letter to their website, ISDA would review and approve the adherence request. Provided the borrower’s cap or swap provider also chose to adhere to the Protocol, the terms of the Supplement would then be incorporated into all caps and swaps between the CRE borrower and the cap/swap provider. This form of adherence may be done at no cost through January 25, 2021, and thereafter will cost $500.
The ISDA has also published several template bilateral amendments that may be used in lieu of the Protocol. They contain modifications to the standard Supplement that may be useful to the holder of a cap or swap in certain circumstances. For instance, one of the template bilateral agreements addresses situations in which a holder of multiple caps and/or swaps wants the terms of the Supplement to only apply to some, but not all, of their caps/swaps. Another removes the pre-cessation trigger. These bilateral amendments must be circulated and signed by both the CRE borrower and the cap/swap provider, much like a more traditional amendment of a contract.
In addition to these ISDA-provided approaches, the parties to a cap or swap may, like in any other contract, agree bilaterally to incorporate the terms of the Supplement (or any other terms) via an amendment that the parties draft and negotiate themselves.
It’s important to understand that, regardless of the approach used, incorporation of the terms of the Supplement to pre-existing caps and swaps requires the consent of both parties to the trades. CRE borrowers cannot be forced to incorporate them, nor can they compel their cap/swap provider to incorporate them. In cases where the the lender required a cap or swap on the underlying loan, the lender will likely also have to approve their incorporation. (Back to top)
Should I expect my cap/swap provider to ask me to incorporate the Supplement into my pre-existing cap or swap?
If you have an existing LIBOR cap or swap in place that expires beyond 2021, you should expect to hear from your provider in the coming months about taking some action to incorporate the terms of the Supplement. Chatham is reaching out to the banks which provide caps and swaps to our clients to confirm how they expect to handle this. Some have already confirmed that they will ask CRE borrowers to adhere to the protocol. Others are still undecided. We expect that some may prefer to prepare their own bank-specific bilateral forms to be used in lieu of the Protocol. Please reach out to your Chatham representative if you have a question about a specific bank. (Back to top)
What happens if I do not incorporate the Supplement into my pre-existing LIBOR cap or swap?
Pre-existing LIBOR caps and swaps which do not incorporate the terms of the Supplement will continue the use the legacy ISDA LIBOR fallback language. This takes effect if LIBOR becomes unavailable and requires the calculation agent (typically the provider of the cap or swap) to determine a proxy for LIBOR by polling other banks as to their cost of funds. Importantly, this legacy fallback language does not include any kind of pre-cessation trigger. Provided LIBOR continues to be published, the cap or swap would continue to use LIBOR, even if LIBOR was determined to be non-representative and was no longer used broadly in the financial markets.
In a best case, LIBOR caps and swaps that don’t incorporate the Supplement (or something similar) would continue to reference LIBOR even after the rest of the market had moved away from it. This will create mismatches between the cap or the swap and the underlying loan if the loan has already transitioned to SOFR. In a worst case, if LIBOR actually ceased to be published, then the calculation agent would be required to use the polling mechanism to determine a proxy LIBOR, though it is unclear if they’d be able to do so if LIBOR has gone away entirely; they may not be able to find banks willing to provide cost of fund quotes. In this case, it is ambiguous if and how the cap or swap would function at all.
It is worth noting that there is proposed legislation in the State of New York (the jurisdiction for most caps and swaps) that would address this by eliminating this polling fallback language and replacing it with the provisions of the Supplement. While the fate of this legislation is uncertain, if passed it would essentially incorporate via legislative fiat the terms of the Supplement into any pre-existing caps or swaps that hadn’t already incorporated it via some other means. (Back to top)
Business impact of implementing the ISDA IBOR Fallbacks Supplement/Protocol
Should I elect to incorporate the Supplement into my pre-existing LIBOR caps or swap?
The existing fallback language in caps and swaps for LIBOR unavailability is problematic for a permanent cessation of LIBOR. Any existing LIBOR cap or swap that matures after LIBOR ceases to be quoted will need some change in fallback language to continue to function. Taken alone, this would seem to suggest that CRE borrowers should look to incorporate the Supplement into their existing caps and swaps. We think it is important to make this decision only after considering the underlying loan, the lender, and potential operational issues.
LIBOR-indexed loans will contain their own provisions for handling the LIBOR transition. Some loans (particularly more recently closed ones) will have language similar to the language in the Supplement — the loan and the cap or swap may track closely. Other loans may have language that is very different from the language in the Supplement, which could result in economic mismatches between the cap/swap and the loan. These mismatches will tend to be one or more of the following:
- Mismatch in the new reference rate: The fallback index for a loan may not match the 30-day compound SOFR rate (set in arrears) under the Supplement. In some cases, the mismatch may be small and of little business significance — the loan may use a daily average SOFR rate which will track 30-day compound SOFR closely. In other cases, the difference may be more significant; many older originations may fall back to the Prime rate, which is a very different rate than SOFR. Many loans may not reference a specific rate at all but rather give the discretion to the lender to select an “appropriate” rate informed by current market convention.
- Mismatch in the spread adjustment: Most loans, like the Supplement, prescribe a change in the loan spread in the event that LIBOR is replaced with another reference rate like SOFR to account for the difference between the two; this is intended to ensure that the all-in coupon on the loan does not change when LIBOR is replaced. If the spread adjustment in the loan does not match the supplement, the mismatch could impact this all-in coupon. While more recently closed loans may use the same approach as the Supplement, many loans we have reviewed do not. Some loans calculate the spread adjustment based on the difference between LIBOR and SOFR on the day of conversion, not the 5-year historical median difference. Others may have less objective language which leaves discretion for determining the adjustment to the lender.
- Mismatch in the trigger events: While more recently closed loans may have trigger events that match those in the Supplement, many loans do not. This creates the possibility that the underlying loan could transition from LIBOR to an alternative rate at a different point than the cap or swap does. Some loans give the lender discretion, often without borrower input, to choose when the loan transitions based on their subjective judgement. This would permit the lender to transition the loan to SOFR prior to the cap or swap transitioning (perhaps because the lender has started indexing new originations to SOFR). Alternatively, the lender could choose to delay the transition to SOFR on the loan until well after the cap or swap does, perhaps because there is lender favorable “alternative base rate” language in the loan.
- Loan conforming changes: Many loans drafted with the LIBOR transition in mind include language that gives the lender wide latitude to adjust the operational mechanics of terms like the interest rate reset date and payment dates in order to ensure smooth administration (from their perspective) of the loan. These “conforming changes” provisions are designed to ensure that the lender does not inadvertently agree to LIBOR transition provisions that are difficult or impossible for them support operationally. A borrower should be aware that these provisions may allow the lender to further modify the loan terms upon a transition beyond what’s explicitly defined in the loan. Such modifications would likely result in further deviations from the terms of any cap or swap that will incorporate the Supplement.
Apart from mismatches between the fallback language in the loan and the cap or swap, there are often broader lender considerations. Interest rate hedges are often required by and assigned to the lender. A CRE borrower may not be able to incorporate the ISDA Supplement without the consent of the lender, or the loan agreement itself might have language which dictates how the associated cap or swap needs to be treated if the loan converts from LIBOR to another index. Lenders may prefer to use a different approach than what is explicitly written in the loan agreement since that language was often drafted when there was more uncertainty around how the LIBOR transition would proceed. This suggests careful coordination with lenders before taking any action to incorporate the Supplement or otherwise modify a cap or swap.
Finally, there are operational impacts from the Supplement that a CRE borrower should consider. Most significant of these is the change in the reset date, mentioned above, from the start of the interest period to the end of the interest period. For products like interest rate caps, where the borrower may only ever receive a payment, this may not be problematic; the borrower is more concerned about the timing of the payment itself (which won’t change) rather than the timing of the rate which is used in its determination. For swaps, where the borrower may be a net payer, this may be more problematic. With the reset date occurring two business days prior to the payment date itself, the borrower will only have two days between determining the payment and making the payment.
A CRE borrower should apply the following approach when evaluating incorporation of the Supplement:
- Determine the extent to which the cap or swap needs to match the loan perfectly (whether via lender requirement or otherwise)
- Evaluate the extent to which the Supplement provisions mirror loan fallback provisions, quantifying the differences when possible
- Decide whether the differences (and consequently the Supplement) are acceptable or not, in which case the borrower will need to consider a bespoke amendment or restructuring of the trade (Back to top)
Mismatches in fallback language between the Supplement and my loan agreement are a big consideration. How does the typical floating-rate loan handle LIBOR replacement?
Unfortunately, there is not consistency in how legacy loans handle LIBOR replacement. The language tends to differ by lender and by the “vintage” of the loan; older loans tend to have language that is less supportive of a LIBOR transition while more recent loans have language which is more supportive. We have observed some common general constructs, including:
- “Alternative base rate” approach: This language replaces LIBOR with some other well-established market rates, like the Fed Funds Rate or the Prime Rate. The trigger for replacement is often LIBOR becoming unavailable or the lender deeming that it is not representative of their cost of funds. There may be a spread adjustment to account for the difference between LIBOR and the new index rate, but it is often insufficient, with the result being an increase in the coupon paid by the borrower. This language is usually not borrower friendly and not consistent with the terms of the Supplement. It’s most common in older vintage loans.
- “Lender discretion” approach: This language gives the lender broad discretion as to when LIBOR is replaced as the loan index, the rate which replaces it, and adjustments to the spread (if any) made to preserve the all-in coupon of the loan. This language may be subject to commercial practicality, broader market practice, or what the lender is doing with other borrowers.
- “Hedged loan” approach: This language forces the loan to mirror the fallback language in the cap or swap hedging it. While this language is not yet common as of this writing, it has been used by some lenders in swapped floaters and is an approach endorsed by the Alternative Reference Rate Committee (ARRC) for hedged loans.
- ARRC “hardwired” approach: The ARRC, which is seeking to drive consistency in approach in the commercial lending community, has endorsed several approaches for fallback language in different types of loans. Their “hardwired” approach is similar to the approach in the Supplement in that it defines an adjusted reference rate, spread adjustment, and trigger events. The spread adjustment and trigger events in the ARRC language closely match those of the Supplement. The adjusted reference rate language differs in that it first looks to “term SOFR”, which is a term SOFR rate that is anticipated to be derived from the SOFR forward curve, though it’s not yet published or ascertainable. This language may also include “early opt-in” language which would permit the lender, under certain circumstances, to trigger a transition of the loan from LIBOR to the SOFR based rate prior to the trigger events. If this early opt-in language is not included, this approach is reasonably consistent with the language of the Supplement.
- ARRC “amendment” approach: As an alternative to their hardwired approach, the ARRC also endorses an “amendment” approach. This approach has the same trigger events and possible early opt-in language as the hardwired approach, but it leaves the adjusted reference rate and spread adjustment language to the discretion of the lender, subject to giving due consideration to any recommendation from the Fed or the ARRC as well as prevailing market convention for similar loans, and may also provide for borrower input or approval. Along with the hardwired approach above, we are starting to see more lenders use this ARRC recommended language, or language like it, in new loan originations. (Back to top)
Will the changeover from LIBOR to SOFR impact the value of my cap or swap?
As anyone who has recorded the value of one of their caps or swaps for financial statements knows, these instruments have inherent market value (commonly known as “mark-to-market” value) which may change over the life of the contract. When a cap or swap converts from LIBOR to SOFR, it is possible that the change may impact this mark-to-market value, either increasing or decreasing the value. This “value transfer” (so called because it creates an immediate shift of value from one party of the trade to the other) would occur if either:
- The expected future payments to be made or received under the cap/swap changes
- The perceived likelihood of actual future payments matching those expected payments changes
The former is more intuitive and is the only potential source of value transfer for swaps; the latter captures the impact of volatility on the valuation of option products and is an additional potential source of value transfer for caps.
The Supplement includes a spread adjustment component to capture the historical difference between LIBOR and SOFR. As we approach the actual LIBOR cessation date, the difference between expected future SOFR and expected future LIBOR (i.e., the difference between the SOFR and LIBOR forward curves) will, to avoid an arbitrage situation, converge to match this spread adjustment. If the spread adjustment is 11 basis points, the differential between the two forward curves will be 11 basis points. This will eliminate the possibility of any value transfer due to differences in expected future payments. Since this is the only type of value transfer to which swaps are exposed, we don’t believe CRE borrowers need to worry about this risk for their swaps.
Value transfer due to changes in the certainty of expected future payments, though, is not addressed by the spread adjustment. This type of value transfer could occur and most likely will, at least to a small degree. Unfortunately, we don’t know today which way that value transfer might flow — to the benefit of a cap purchaser or to their detriment. The size and nature of any value transfer will become clearer as we near the LIBOR cessation date, but CRE borrowers that own interest rate caps may find that they need to elect to incorporate the Supplement before this. This will not be a material consideration for caps which don’t have significant market value at the time of LIBOR cessation, including caps with little remaining term or relatively high strike rates. (Back to top)
I have a lender-required interest rate cap. Are there any considerations for this situation?
While all the considerations above apply to a lender-required interest rate cap, only some may be of real business concern. Given the decline of LIBOR coming out of the COVID-19 crisis, many of these caps are very far “out-of-the money”; they have strike rates which are much higher than current LIBOR expectations. Pre-existing caps may also not have much term left beyond the expected LIBOR sunset date. If the cap is far “out-of-the-money” and/or has little remaining term, a potential mismatch in the fallback language between the cap and the loan may not be consequential.
Lender coordination is still important, though. Many loans (particularly for non-bank, non-Agency lenders) have language that gives the lender the right to ask the borrower to modify or restructure a cap when the loan converts from LIBOR to another index. The exact nature of the modification is often at the lender’s discretion and may not be accomplished simply via the incorporation of the ISDA Supplement. This highlights the biggest consideration for CRE borrowers with interest rate caps — the administrative burden of addressing the potential incorporation of the Supplement and any other changes to the cap that the lender may require by right under on the loan agreement. At the very least, this will take coordination between the borrower, lender, and cap provider and may involve costs associated with restructuring the cap, including the $500 fee for incorporating the terms of the Supplement via the ISDA Fallbacks Protocol. In the coming weeks, Chatham will be doing outreach to lenders to better understand how they plan to navigate this situation, so please reach out to us if you have specific questions about a lender with whom you work. (Back to top)
I have a loan that has a fixed rate via an interest rate swap. Are there any considerations for this situation?
Swapped floaters are the structure in which a mismatch between the LIBOR fallback language in the loan and the swap is most likely to be noticed by a CRE borrower — any inconsistency could cause a change in the all-in fixed rate paid by the borrower. For example, if the spread adjustment mechanism on the loan results in an adjustment that is greater than the spread adjustment on the swap, the borrower’s fixed coupon will increase by the difference between the two. For this reason, a CRE borrower should not incorporate the Supplement into their swaps without careful understanding of and coordination with the fallback mechanism of the loan. (Back to top)
I placed a forward starting swap to hedge a fixed-rate bond or loan issuance. Are there any considerations for this situation?
Some CRE borrowers use forward starting swaps to hedge base rate risk on bonds or other loans that price over Treasuries or swap rates. There are several potential considerations in these situations with respect to incorporating the terms of the Supplement:
- Value transfer: Most borrowers that use forward starting swaps to hedge a fixed-rate debt issuance elect to have the swaps cash settled — they receive (or make) a lump sum payment on the swap at the same time their loan closes. To the extent that the Supplement is incorporated and the swap converts from a LIBOR-indexed swap to a SOFR-indexed swap, and that conversion causes a change in the mark-to-market value of the swap, this value transfer would impact the payment made or received by the borrower. Fortunately, we don’t believe value transfer to be a significant concern for interest rate swaps.
- Basis risk: Borrowers using swaps to hedge debt that prices over Treasuries face basis risk: the risk that Treasury yields don’t move commensurately with swap rates between execution of the swap and pricing of the debt. This risk would apply to both LIBOR- and SOFR-indexed swaps. The basis between a swap and Treasuries after it transitions from LIBOR to SOFR should be the same as before the transition; there will still be basis risk between the swap and Treasury yields, but it won’t change in magnitude simply because the swap converted from LIBOR to SOFR.
In a situation where the borrower is using a swap to hedge debt that is pricing over swap rates rather than Treasuries, basis risk exists if the underlying debt ends up pricing over a different index than the swap. If the hedge incorporates the Supplement and converts from a LIBOR- to a SOFR-indexed swap, but the hedged debt still prices over a LIBOR swap, there will be basis risk. Conversely, if the borrower believes the debt will price over LIBOR swap rates, hedges accordingly, but then the debt ends up pricing over SOFR swap rates before the hedge converts from LIBOR to SOFR, there is also basis risk. Of the two scenarios, we believe the latter to be more likely — we could envision CMBS lenders pricing loans over SOFR swap rates prior to the occurrence of a trigger event in the Supplement. Borrowers forward hedging fixed-rate debt that they anticipate will price over swap rates, particularly over the course of next year, should talk with their lenders about this before entering into a hedge. (Back to top)
I designate my caps and swaps as hedges under GAAP/IFRS. How will a conversion of a pre-existing cap or swap from LIBOR to SOFR impact my hedge designation?
On March 12, 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (Topic 848; ASU 2020-04). ASU 2020-04 contains practical expedients for reference rate reform-related activities that impact debt, leases, derivatives, and other contracts. The guidance in ASU 2020-04 is optional and may be elected over time as reference rate reform activities occur. Application of these expedients preserves the presentation of derivatives consistent with past presentation. The accounting relief provided by ASC 848 is applicable only to legacy contracts if the amendments made to the agreements are solely for reference rate reform activities. Modifications that are unrelated to reference rate reform will scope out a given contract (see ASC 848-20-15-2 through 15-6).
Put more succinctly, incorporating the terms of the Supplement should not impact hedge designation if proper elections are selected under the FASB accounting relief guidance. (Back to top)
Once my cap/swap transitions to SOFR, what happens if SOFR ceases to be published?
The Supplement does provide a fallback mechanism for SOFR itself. If the relevant SOFR rate is temporarily unavailable, then the most recent prior SOFR rate is used. If the relevant SOFR rate is expected to be permanently unavailable, or is otherwise declared unrepresentative, the Supplement progresses through a waterfall which begins with whatever index is explicitly named by the Federal Reserve as the successor to SOFR, looking next to the Overnight Bank Funding Rate as published by the Federal Reserve Bank of New York, and then finally to the FOMC target rate. (Back to top)
Are there tax consequences associated with incorporating the Supplement's provisions into my cap or swap?
On October 9, 2020, the Internal Revenue Service issued Revenue Procedures (Rev Proc) 2020-44 which provides guidance on the application of modifications to financial instruments via the Supplement. Specifically, the guidance provides for safe harbor from certain unfavorable tax outcomes which may otherwise be associated with economic changes to caps and swaps. This safe harbor may not extend to modifications made using language other than that in the Supplement. Please consult your tax advisor for further questions on the tax consequences associated with the terms of the Supplement. (Back to top)
Talk to an ISDA expert
Talk to an ISDA expert about how the IBOR Fallbacks Protocol may affect your organization.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
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.20-0413
Our featured insights
U.S. real estate market update—May 11, 2020
This summarizes the impacts that COVID-19 has had on repo markets and SOFR, how market participants have responded, and the possible implications of the economic slowdown on the LIBOR-SOFR transition.
U.S. real estate market update—March 30, 2020
While the week prior was a big week for monetary policy, with the Fed taking wide ranging policy actions to strengthen liquidity in credit markets, this past week ended with a bang for fiscal policy.
A tour of Europe — an update on interest rates
A brief update on the EUR, SEK, and GBP interest rate conditions, putting the recent year-to-date movements into the context of the last 12 months.
The hairy chart: Historical accuracy of LIBOR forward curves
These hairy chart graphs plot past LIBOR forward curves against the actual path LIBOR followed, showing that the forward curve has been a somewhat accurate predictor over the next six months or so...
Request your interest rate cap execution checklist
Understanding the tactical steps involved in executing on an interest rate cap can help CRE investors plan and use their time efficiently prior to closing on a loan. Request your interest rate cap execution checklist here.
Thought leadership for housing associations: Embedded swaps and SONIA
There is emerging evidence that the way the housing association sector hedges its interest risk will change in the coming year. Currently, most are able to fix the debt through an embedded swap (a fixed-rate loan or “FRL”). FRLs account for the majority of fixed-rate borrowing for most small to...
Steepening yield curve increases cost of GBP interest rate hedging
A series of government bond selloffs have jolted financial markets since the start of 2021. In the UK, one consequence is a sharp rise in the cost of hedging GBP interest rate exposures. Having started the year at 0.08%, the five-year swap rate on 3-month GBP LIBOR hit 0.52% at the end of...
LIBOR transition timing update — the regulators have spoken
This piece summarizes a series of public announcements on March 5 regarding the timing of LIBOR cessation. Most notably, one- and three-month USD LIBOR will be published through June 30, 2023, while all non-USD LIBOR settings (GBP, EUR, CHF, JPY) will be published through December 31, 2021....
U.S. real estate market update—February 26, 2021
Markets are pricing in the first 25 basis points of Fed rate hikes to occur mid-2023 versus early-2024. Benchmark Treasury yields hit their highest points since the start of the COVID-19 pandemic and the levels strained liquidity in U.S. interest rate markets.
Rising yields and a steepening curve — U.S.
Longer-duration yields have risen and the yield curve has steepened in a hurry. 10-year yield touched 1.55% on February 25. The last time it crossed 1.50% was a year ago before the COVID-19 pandemic. The 10-year yield fell below 0.60% on March 9, stayed around 0.60-0.70% for months till...