Companies are hanging onto the London interbank offered rate for existing loans and derivatives despite a push from regulators to abandon the troubled interest-rate benchmark, whose demise is about a year away.
Financial authorities started phasing out Libor in 2017 after traders at large banks manipulated the rate, which underpins trillions of dollars of financial contracts, such as mortgages, corporate loans and interest-rate derivatives. The benchmark is set to expire by June 30, 2023.
Since Jan. 1 of this year, companies have had to link new debt to benchmarks other than Libor, as U.S. banks could no longer issue Libor-linked loans, with most of them picking the Secured Overnight Financing Rate, or SOFR.
But there are still a lot of existing loans tied to Libor on the books, and companies are trading Libor derivatives to hedge financial risks stemming from high inflation and interest rate increases, corporate advisers said.
“We’re going to see Libor-based hedging as long as there is Libor-based debt to be hedged,” said
managing partner and global head of corporates at Chatham Financial, a financial-risk adviser.
Companies usually replace Libor when they refinance their loans. But they might decide against refinancing now, possibly because they did so last year and want to avoid the incremental cost of doing it again, Mr. Dhargalkar said. Companies didn’t have to swap out Libor in financings completed in 2021, so many companies simply stuck with it when they refinanced, adding language that allows for a transition to SOFR if necessary, he said.
Average daily trading volumes of Libor-based derivatives continue to exceed that of those linked to SOFR. Over $2.33 trillion of futures and options contracts tied to Libor changed hands each day in May, down from $2.99 trillion in May 2021, according to exchange operator
CME Group Inc.
About $1.9 trillion in SOFR-based derivatives were traded in May, up from $189.36 billion a year earlier.
“Some companies don’t want to wait until they have SOFR-based debt to hedge their exposure,” Mr. Dhargalkar said. “They say, ‘I’m just going to hedge my Libor exposure right now.’”
Among the companies doing that is retirement-home operator Brookdale Senior Living Inc. The Brentwood, Tenn.-based company typically buys interest rate caps related to its variable debt to reduce potential rate volatility, said Chief Financial Officer
Brookdale still has Libor-linked loans amounting to 91% of its variable-debt stack, he said. The company placed most of these loans, which carry seven- to 10-year maturities, before the Libor phaseout was announced, he said. “We have expanded our monitoring of forward rates to include SOFR,” Mr. Swain said. The company expects these loans will be transferred to SOFR as of the deadline, he said.
Companies across industries often enter into interest rate swap or cap agreements to limit their exposure to interest rate terms on their variable-rate loans. Tanker operator Pyxis Tankers Inc. has interest rate caps covering part of the $70 million it has in outstanding Libor-based bank debt, CFO
said. The Maroussi, Greece-based company, which is listed on the Nasdaq, last July purchased a four-year cap to cover the $9.5 million balance of a ship loan, he said.
Asked when Pyxis Tankers will switch its loans to SOFR, Mr. Williams said the company will coordinate with lenders, as the transition is already baked into its loan agreements. “Our two principal banks still use one- and three-month Libor,” he said, referring to
and Vista Bank. Pyxis will consider purchasing SOFR caps, swaps or collars, which are essentially swaps with a range, to hedge interest-rate risk after the switch, he said.
Trading volumes for SOFR derivatives have far outperformed those of other benchmarks, excluding Libor, indicating it is the preferred alternative. Some small or midmarket companies are considering the Bloomberg Short Term Bank Yield Index, for example, but the volume for instruments linked to that standard is much lower.
“We did see for a brief period more interest in people exploring credit-sensitive alternatives, but that really has gone away and the impulse seems to be, even in the middle market, SOFR,” said
J. Paul Forrester,
a partner at law firm Mayer Brown LLP.
Companies in recent years have added fallback language to most loans allowing for a switch to a Libor replacement in June 2023. The International Swaps and Derivatives Association Inc., a derivatives trade group, in 2020 issued guidance on fallback language for derivatives.
There can be cases in which companies’ legacy instruments don’t allow for a fallback to SOFR and therefore would use the prime rate, the rate at which banks lend to customers with good credit, Mr. Dhargalkar said. President Biden in March signed a law allowing certain older financial contracts to automatically switch to SOFR or another rate.
The volume of Libor hedging is expected to decline as more companies make the changeover ahead of the deadline, advisers and regulators said. Businesses’ new debt issuances linked to SOFR, for example, have been picking up speed. U.S. companies in May sold 13 leveraged loans tied to SOFR, compared with zero in May 2021, according to Leveraged Commentary & Data, a data provider.
Still, regulators want companies to link their loans to SOFR sooner rather than later to ensure a smooth changeover. “We probably have to get a little closer to the end before that sense of urgency overtakes the market,” said
head of the Alternative Reference Rates Committee, a group of financial institutions handling the transition with the Federal Reserve Bank of New York. “We just hope people don’t get too close to the end.”
Write to Mark Maurer at Mark.Maurer@wsj.com
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