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By: Sam Gruer, Managing Director
As regular readers of Basis Points are aware, the London Interbank Offering Rate (LIBOR) is expected to be phased out and replaced with the Secured Overnight Financing Rate (SOFR). While there are many fundamental differences between these indices which we have previously discussed, a recent development in this process is worthy of highlighting. Specifically, the International Swap and Derivatives Association (ISDA) has released a new protocol – the IBOR Fallbacks protocol – to address legacy swap transactions based upon LIBOR and how they will convert to SOFR. As a result, many dealers have begun requesting their counterparties, including swap end-users like the higher education, healthcare, and non-profit organizations that we serve, to adopt these protocols. To avoid a disruption or a logistical bottleneck for the industry, ISDA has created an incentive for early adherence of this protocol by waiving the administrative fee for those adopting prior to January 25, 2021. Whether or not taking this action is advisable for end-users varies. The protocol specifies that once LIBOR is discontinued, the transaction will fall back to a term-adjusted risk-free rate plus a spread, consistent with the Alternative Reference Rate Committee (ARRC) recommendations and calculations. While this may sound straightforward and non-controversial, Blue Rose has independently calculated the potential impact from the fallback indices on the valuation of existing interest rate swap transactions, and the results can be eye opening as shown in the table below.
*As of December 2, 2020
Specifically, Blue Rose has constructed forward curves using the ARRC’s fallback spreads assuming the date of each analysis was the date upon which the LIBOR index was discontinued. What has been discovered is, depending on the tenor of a swap and the date on which we performed the calculation, there can be meaningful differences between the SOFR and LIBOR swap curves which, as a result, have valuation implications for each transaction. While it is not yet clear if there is sufficient liquidity in the market to actually execute a swap transaction utilizing the SOFR yield curve, it might be worth exploring with dealer counterparties whether it is feasible to make adjustments to swaps, in order to preserve their value, prior to adhering to the IBOR Fallbacks protocol. Given the findings of our analyses, we believe it is imperative that every organization that utilizes derivatives individually assess the impact of the ISDA protocols on their particular derivatives portfolio before deciding if, when, and/or how to adhere to the protocol. For more information on this topic, as well as how this may also impact LIBOR-based debt instruments, please contact a Blue Rose advisor.
About the Author:
Sam Gruer, Managing Director:
Sam Gruer, a 30-year municipal market veteran, joined Blue Rose in 2017 as a Managing Director and leader of the firm’s reinvestment business unit. Mr. Gruer guides his clients through the debt/swap/reinvestment transaction process by making strategic recommendations based on sound, thoughtful, and sophisticated analysis. He also offers expert advice on determining the optimal structure for reinvestment of bond proceeds by evaluating risk tolerance, identifying legal restrictions and estimating cash flow needs for his clients. He serves clients from our Roseland, New Jersey office. Mr. Gruer can be reached at: sgruer@blueroseadvisors.com