Gazing into 2022, SOFR remains the first choice among borrowers, but may still require “mathematical gymnastics.”
The year-end deadline for pricing new floating-rate transactions over Libor replacement rates and a steepening but uncertain yield curve prompted assistant treasurers from large-cap companies to tap the insights of rate and hedging experts from Chatham Financial at a recent meeting.
- Companies are looking to increase their floating-rate exposure compared to a year ago, generally because they are at the higher end of their fixed/floating mix, according to Amol Dhargalkar, managing partner and global head of corporates at Chatham. Some investment-grade companies primarily funding through the bond market have considered swapping to floating, he said, although that’s a tough sell to CFOs as rate increase appear highly likely.
- The requirement to price new debt and derivatives over an alternative to Libor starting in January raises a host of issues.
Pre-issuance hedging. Market volatility has increased the importance of pre-issuance hedges, but how to structure them?
- “For companies using swaps to hedge future issuance, Libor is no longer an option so companies are using compounded SOFR trades,” said Kevin Jones, treasury advisory, corporates, at Chatham.
Waiting on term SOFR. Chatham has received numerous inquiries from corporate clients about term SOFR, published by the CME and echoing Libor’s term structure.
- “The problem is that there’s not a lot of liquidity in term SOFR just yet,” Mr. Jones said. “I think this is going to change starting next year, but we’re not there yet.”
- Consequently, most derivatives have been priced over SOFR compounded in arrears, which requires some “mathematical gymnastics to get the rate right.”
- Chatham has also seen some derivative trades price over daily simple SOFR and SOFR compounded in advance.
- Those opting for term SOFR on a derivative trade will likely face additional charges or premiums, since bank counterparties will be less able to lay off that risk.
On the ground. Few members acknowledged having used a Libor-replacement rate. One who priced a hedge over SOFR said they paid a premium, adding that “based on the fixed conversion from Libor to SOFR, we expect to get the value on the back end.”
- He added that the biggest challenge was making sure the company’s accounting system supported the transaction.
On the debt side. The revolver of one member’s company allows borrowing in three currencies. He said the reference rate for borrowings over pound-sterling Libor is mandated to be replaced by the UK’s Sonia by year-end, and the transaction will soon be amended. No change was necessary for euro borrowings, which are not priced over Libor to begin with.
- Another member said her company doesn’t borrow in other currencies, but the administration agent of its revolver nevertheless insisted on making that restriction formal.
SOFR alternatives? Some regional banks criticize SOFR’s lack of credit sensitivity and prefer the American Financial Exchange’s Ameribor or the Bloomberg Short-Term Bank Yield Index (BSBY), but the biggest financial institutions are now leaning toward SOFR. A member noted one large global bank still expresses support for BSBY and asked whether that was likely to continue.
- Mr. Dhargalkar said that criticism of BSBY by regulators, including SEC Chair Gary Gensler saying it echoes Libor’s weaknesses, bring its widespread usage into question.
- A member noted that the recent renewal of his company’s five-year revolver includes language enabling the use of Libor as long as it is available, and hardwire fallback language switching it to term SOFR plus the official spread adjustment.
- “We also negotiated being able to adopt another reference rate, in the event BSBY or another rate ends up becoming predominant, with negative consent from our bank group,” he said.