Getting valuations right for the IBOR transition
I’m a fan of James Bond films and can think of at least three films that included scenes on a train. There’s something high-stakes and action-filled about trains on the move.
I see some parallels between moving trains and the transition away from Inter-Bank Overnight Rates (IBOR). Many of us are on a train called “LIBOR-based rates,” and we’ve got to jump off this moving train and onto another one by the end of 2021, when IBOR-based rates are anticipated to be discontinued. We may not like the situation, but we have to take the jump because various obstacles are fast approaching. The main problem is that no one knows the details about the train we’ve got to jump to. It feels like we’ll be taking a leap into the unknown.
There are multiple concerns with this anticipated change, but the fundamental challenge is that LIBOR is a term-based rate, while the Secured Overnight Financing Rate (or “SOFR”), which is the main alternative under discussion in the United States, is an overnight rate. Since the structures are fundamentally different, trying to convert from an overnight rate to a term structured rate will require either a liquid SOFR futures market to develop or an alternative method be developed. Either way, this conversion on existing contracts will result in an impact to be felt. In other words, there will be winners and losers.
Entities with open contracts extending past the transition date may see their contracts decline in value when they jump, and some will experience the opposite. The additional concerns are that various valuation techniques such as back-testing and access to implied data, are non-existent. All this leads to difficulty with valuations, to say the least.
LIBOR presently underlies assets that are estimated to total more than 350 trillion U.S. dollars in notional amount, and the rate is the basis for calculating mortgages, corporate loans, government bonds, credit cards, as well as a variety of eurodollar and interest rate derivatives. In addition, it is sometimes utilized as the basis for discounting various types of financial instruments.
I estimate it will take companies two to three years to manage the transition, and many have not even started with the first step in managing the process – assessing your IBOR exposure.
Taking this step now is critical, since the “fix” or “treatment” to manage each instance of exposure is different. Each contract can include a variety of instruments and counterparties. In many cases, negotiations with banks will be necessary.
I’d like to walk you through three types of instruments commonly used by companies that will be strongly impacted by the transition from IBOR and share some concerns about them. They are variable-rate loans, interest-rate swaps and interest-rate options.
Let’s first look at how the IBOR transition will impact variable-rate loans. Consider a small to mid-sized, capital-intensive company with 50 million to 5 billion U.S. dollars in revenue. Perhaps it is a power generation company that needs to invest in heavy equipment and plants.
Since most of these types of companies have debt, and most of their loan contracts are mid to long-term, a company like this is likely to have a fair share of debt that extends past the IBOR transition date of year end 2021.
The first concern the company should have about these types of contracts is if they contain language that addresses a transition of this nature. The provisions will need to be highly scrutinized as fallback language was not initially designed for this type of dislocation; it was more short-term in nature so even if there is language addressing a disruption, it may not be suitable for the company’s purposes going forward. Assuming there is no fallback language in the agreement, and assuming it’s not possible or desired to end the contract, the company will have to take other actions such as renegotiating or modifying the contract.
If a company chooses to renegotiate, it can renegotiate the index itself, which is the pricing component of the contract, and change it to the new alternative reference rate. As this approach is going to ultimately change the agreed upon cash flows and the value of the instrument, it will most likely result in a gain or a loss, therefore it’s critical to have an agreed upon method in place for handling each case.
As I like to tell my clients, the focus of transitioning early is to properly assess the exposures on an entity-level basis. As some of the required changes may have prescribed dependencies and involve multiple parties, achieving these objectives will take time.
Other valuation approaches under discussion are to take a static adjustment to the exposure or look at the history of SOFR rates to make a projection. But as previously mentioned, SOFR information is not that readily available and the breadth of the information does not compare to existing IBOR rates.
Another option is for the company to continue with its existing LIBOR basis and hope a synthetic LIBOR index will be available for the medium term. Companies on this path need to recognize that they may go through the effort of managing and adjusting the contract multiple times if the synthetic LIBOR rate does not become available or is no longer available at some point in the future. In addition, the prevalence of LIBOR based products may diminish significantly at a future point, thereby making this approach outside of industry norms.
As you can see, the matter is complex and the right treatment will be nuanced for each individual case. That’s why I stress how important it is to have your program up and running now. Companies of this size should already have buy-in from senior management, an overview of the milestones that need to be achieved and a transition team in place with skills in contract management, financial reporting, accounting, compliance, IT, valuations, risk management and treasury. That is how involved these projects may turn out to be.
Companies that have variable-rate debt often have an associated interest-rate swap to go along with that debt.
The concerns here are similar to those I discussed above. How long is the contract for the interest rate swap? Does the swap match the debt to maturity? How different are the terms on the swap, compared to the terms on the debt?
And then you get into valuation questions. How is the swap being valued? Is the valuation performed through an automated system or manually? This may impact IT, and it also raises accounting questions – e.g. are you using hedge accounting on the swap?
If you’ve entered into any sort of derivative, a more thorough analysis will have to be performed to assess the potential impacts. The ISDA and all supporting documents will have to be evaluated to ensure that the language has been updated with the most current acceptable fallback language. If not, valuation and settlement concerns may be raised. Additionally, approaches such as whether derivative will be modified or monetized will have to be considered.
The options for treatment are also similar for variable-rate contracts, such as terminating the contract, renegotiating it or moving forward with the existing risk. And, of course, the choice of treatments will impact the financial reporting that ultimately matters.
You see how complicated all this is. It’s hard to believe, but some companies are still entering into LIBOR-based contracts. I can only hope that those contracts have fallback language.
To manage this transition effectively, it is considered prudent to assess the level of exposure present and then rank the exposures systematically, based on various factors such as the materiality and the potential cost of the treatment involved. This will provide a rational methodology for determining a course of action.
The final instrument I want to discuss is interest-rate options, which can be standalone instruments or can be combined with other instruments we’ve discussed previously.
Let’s say the counterparty, which is a bank, has an interest rate swap that contains an interest rate cap embedded in the instrument. The embedded option requires various valuation inputs, such as implied volatility, that is going to make it inherently more complex to value.
When moving away from IBOR, the question becomes – how do you calculate the volatility of an index (e.g. SOFR) that hasn’t been around for long and doesn’t have liquid futures pricing? Good question. I agree.
For interest-rate options, the concerns are similar as for the two other instruments we’ve discussed. However, options are a tougher nut to crack because of the volatility component. Instead of just calculating the price differences between instruments, with options, companies must also consider volatility. That makes the valuation much more complex.
If I take this back to my train metaphor, I’d have to say that the train that options owners must jump to is not only moving, it’s also bumping up and down because of debris on the tracks. And that makes the leap into the dark on interest-rate options even more difficult.
It’s a mammoth task to convert from a widely used index to one that is in its infancy.
Even James Bond won’t have a quick fix for this one.