Basis Risk of Floating Rate Loans

In connection with the likely cessation of LIBOR as a viable index at the end of 2021 or earlier, any borrower with floating rate loans based on LIBOR that has hedged, or plans to hedge, the floating rate exposure on those loans by entering into interest rate swaps should be aware of potential “basis risk.” The basis risk is the potential mismatch between the floating rate paid by the borrower on the hedged loan and the floating rate received by the borrower on the related swap.

Floating Rate Loan Documents

Almost all loan documents with floating rate loans include “fallback” provisions specifying how the floating rate will be determined once LIBOR is no longer available and quoted as a viable floating rate index. Amendments to credit agreements currently being implemented are likely to include updates to these LIBOR fallback provisions, with a floating rate based on Secured Overnight Financing Rate (SOFR) as the likely base of the new floating rate index.

Interest Rate Swaps Post-LIBOR

A borrower’s obligations under an interest rate swap are governed by a separate International Swaps and Derivatives Association (ISDA) Master Agreement (and certain incorporated ISDA Definitions) rather than by the hedged loan documents.  The ISDA Master Agreement also includes fallback provisions that will become applicable once LIBOR is no longer quoted as a viable index. As currently drafted, the ISDA fallback provisions will not be satisfactory to address the permanent unavailability of LIBOR, but ISDA is expected to release amended definitions in July 2020 that specify a more workable alternative floating rate index, which will also be SOFR-based. The new ISDA fallback provision will automatically apply to swaps entered into after the expected September 2021 effective date and ISDA will provide a streamlined method for borrowers and swap providers to agree to apply the new ISDA fallback provisions to existing interest rate swaps entered into before that effective date.

Potential Disconnect Between Loan & Swaps

While the fallbacks under both loans and swaps are likely to be based on SOFR, there could be significant differences in the way the ultimate amount payable is determined. For example, there might be variations in the following provisions between the loan and swap fallback provisions that potentially expose a borrower to basis risk:

  • Timing of LIBOR unavailability provisions.
  • Whether SOFR is in advance or arrears.
  • How SOFR is converted from an overnight rate to a term rate that matches the prior LIBOR period.
  • The additional spread to account for SOFR status as a “riskless” rate based on overnight Treasury rates.

Risk Potential

Although any spread between the loan and ISDA fallback rates may be sufficiently small to not be a financial concern, those differences could potentially affect how a borrower accounts for the hedge for GAAP and tax purposes.

Suggested Approach for Handling Floating Rate Loans

Before amending fallback provisions in loan documents for swapped debt or entering into new interest rate swap agreements, borrowers should seek help to analyze how those fallback provisions mesh and the potential implications of any mismatch.

If you have any questions about the transition away from LIBOR to SOFR and its impact on your business, please contact the authors.