• Ruth Hardie, Senior Director at GTreasury


• 24.05.2023 10:45 am
#finance

With the June 30 end-of-publication date for the USD London Interbank Offered Rate (LIBOR) fast approaching, pressure is mounting for corporate treasurers to complete their transition to a risk-free rate—with most opting for the Secured Overnight Financing Rate (SOFR). Many appear to be waiting until the last minute to achieve SOFR readiness: global investment company KKR recently estimated that 80% of institutional corporate loans were still tied to LIBOR. 

As someone who has seen plenty of treasury teams who have already made the switch, the overarching lesson is clear: there’s no reason to wait or procrastinate on making the transition to SOFR, and plenty of advantages to completing the shift before it’s too late. Here’s what to know.

SOFR transition details and misconceptions

To navigate the shift to SOFR, you need clarity on a few key details and misconceptions. 

One key detail is in the differences between daily SOFR and term SOFR. In general, SOFR is more volatile than LIBOR, with daily SOFR rates showing increased volatility at the end of quarterly and annual periods, and term SOFR rates offering more stability. While some users find the increased volatility concerning, most are satisfied that the increased transparency of SOFR, and the risk-free rates replacing LIBOR in other countries more than make up for the increased volatility. The majority of floating-rate corporate debt will roll into forward-looking term SOFR rates. Many treasurers now transitioning are actively working with their banks to negotiate term SOFR derivatives that match the tenor of LIBOR they are replacing. Other treasurers—observing daily SOFR rates that are lower than term SOFR—have been opting to keep daily SOFR and live with the mismatch. 

That said, many treasurers falsely believe this misconception: that the ISDA protocol will take care of all their needs. Treasurers may wish to think that SOFR will automatically match the structure of their LIBOR loans. That simply isn’t the case, as treasurers pursuing their SOFR transitions are coming to realize. For those that follow the ISDA protocol, their derivatives will roll into a daily SOFR plus a fixed spread. Ultimately, whether term SOFR (which trades at a spread over daily SOFR) or daily SOFR is right for you will depend on your debt terms and your risk appetite.

Another major misconception centres on ASC 848 and treasurers’ ability to leverage optional elections to modify contracts with terms affected by the shift to SOFR. That ASC 848 relief was recently extended through December 31, 2024. The misconception is that treasurers believe they can use those optional elections all the way through that date, which is only true if they’re still using a rate that’s impacted by reference rate reform. From an accounting perspective, as soon as the hedged item and derivative are both on the replacement rate, treasurers can no longer use the optional elections. This means that if any new, untested differences have been introduced into the hedge relationship, they must be tested for effectiveness no later than the end of the quarter. 

Treasurers must also update their hedge documentation throughout ASC 848 transitions, doing so no later than the quarter-end immediately after the critical terms of either the derivative or the hedged item change. This is another misconception: many treasurers don’t think they need to update hedge documentation until the entire transition to SOFR is complete. In reality, whenever the critical terms are changed, treasurers are using an optional election and their hedge documentation needs to be updated. 

Put your SOFR readiness to the test

To prepare for the shift to SOFR, treasurers must do the following:

1) Establish a transition management protocol. This will serve as a guidebook that will help you “land the plane,” so to speak, when it comes to implementing SOFR. Take the time to make sure your treasury team is fully educated on how to take careful steps and ensure a smooth transition. Be sure to communicate clearly with leaders and other stakeholders as well.

2) Identify and validate your organization’s total LIBOR exposure. Look for exposure and check your fallback provisions on all your asset classes, such as debt, swaps, leases, accounts receivables, transfer pricing contracts, and credit facilities. It’s crucial to understand your potential contract rates in the absence of LIBOR to eliminate unpleasant surprises. 

3) Measure SOFR’s effect on hedge accounting and reporting. The shift to new reference index rates for hedges and debt may impact special hedge accounting. Either way, it’s important to examine the hedge relationship to see if it still delivers on its goals following the shift. Form a plan for keeping hedges and debt aligned even if they shift to different periods, and understand how and when your financial statement footnotes will report on those effects.

4) Contact counterparties. Take the opportunity to prevent risk by negotiating to eliminate any undesirable fallback provisions. Push for matching debt and derivative replacement rates, if that meets your objectives, and understand the transition timing your counterparties are willing to offer. 

Just don’t wait for the absolute last minute

The transition to SOFR is too complex and impactful to take for granted. Treasury teams that dive into the minutiae as soon as possible and invest the time to ensure a favourable transition may reap potential dividends from that investment for some time to come.