Answers to five key questions as you prepare for LIBOR cessation and the fall back to SOFR

1. Why do I need to think about this now?

LIBOR will no longer be published after June 30, 2023, requiring trillions of dollars in floating-rate instruments to reference an alternative rate. For most U.S.-based borrowers, this alternative rate will be SOFR.

2. What happens when LIBOR instruments fall back to SOFR?

If you adopt the standard fallback language, your debt will most likely transition to Term SOFR, while your interest rate hedges will transition to SOFR compounded in arrears (Daily SOFR). This will create an economic mismatch between the two.

The economic difference between these two rates could be material during periods of unexpected Fed rate activity, which would amplify the impact of the economic mismatch between debt and derivative exactly when corporates are most heavily relying on having highly effective hedges in place.

Banks are charging a “Term SOFR” premium in the market to trade on this index as there is currently no interbank trading market for Term SOFR. However, corporations can and should negotiate on this premium.

3. What are my alternatives?

Let interest rate hedges fall back using standard language

While this might be the most straightforward approach in the short term, the mismatch in reference rate will introduce an economic mismatch into the relationship and, potentially, the loss of hedge accounting.

Proactively amend your debt and interest rate hedges

This will give you the opportunity to ensure both your debt and hedges reference the same SOFR rate going forward. However, this approach could introduce substantial SOFR premium charges from your counterparties that result in a less-desirable interest rate and economic result going forward.

4. What are the hedge accounting implications of inaction?

If you apply hedge accounting and currently leverage a qualitative assessment approach such as Shortcut, any of your hedges with an economic mismatch will no longer qualify under a qualitative approach on July 1, 2023. This will trigger a potential de-designation of your hedges and will require a quantitative assessment of effectiveness on a prospective basis.

5. What about ASC 848?

ASC 848 allows for temporary accounting relief as both debt and derivatives transition away from LIBOR. During the period of transition, companies are able to ignore mismatches in the hedging relationship until both the debt and derivative have transitioned away from LIBOR.

With LIBOR scheduled to cease after June 30, 2023, ASC 848 will not offer protection for debt and derivatives that fall back to SOFR. If companies do not proactively amend their debt and derivatives, the potential mismatch between Term SOFR and Daily SOFR will no longer be covered under ASC 848 since both now reference a SOFR rate.

This mismatch will exist for the remainder of the hedging relationship and companies will need to perform a quantitative method of assessing effectiveness to avoid failing out of hedge accounting.

The bottom line

Whether you plan on falling back using standard language or amending your debt and interest rate hedges, it is important to clearly understand each alternative and make an informed decision that best aligns with your organization’s priorities. Chatham has supported organizations through this transition with the following capabilities:

Negotiate transaction amendments

Chatham is a market leader in working with organizations to renegotiate their LIBOR derivatives and avoid any unnecessary Term SOFR transition charges that are commonplace in the market, maximizing your overall interest expense savings.

Provide required new accounting designation

For companies currently applying a qualitative assessment approach and will have an economic mismatch after June 30, a redesignation of your derivatives applying hedge accounting may be required and quantitative testing will be required prospectively. Chatham is the industry-leading expert in operationally supporting the SOFR transition, and will advise on OCI treatment post-de-designation, as well as the appropriate new documentation required to establish a new relationship.

Provide ongoing hedge accounting journal entries and effectiveness testing

Chatham provides outsourced hedge accounting services for over 700 companies. In this capacity, we eliminate the administrative burden of manual ongoing quantitative testing. In addition to receiving journal entries, we will provide you with tailored market knowledge and insights to ensure your organization receives the maximum benefit from your hedging programs.

Support and streamline your program with end-to-end technology

ChathamDirect is a market-leading financial risk management tool that enables organizations to automate labor-intensive hedge accounting activities, financial reporting, disclosure reporting, and management reporting on your program results and effectiveness.

(Related insight: Read, "Five new LIBOR questions your organization must answer before June 30.")