Valuation Considerations and Challenges for LIBOR Transition
The imminent end of the London Inter-Bank Offered Rate (LIBOR) after its five-decade prominence as the primary benchmark rate has prompted many companies to start allocating resources to focus on transition readiness programs. As the LIBOR is set to be phased out by the end of 2021, market practitioners are expected to have implemented processes and procedures for adopting new alternative reference rates (ARRs) for its floating rate financial instruments.
While the Secured Overnight Financing Rate (SOFR) has been recommended by the Alternative Reference Rates Committee as the preferred ARR for USD denominated instruments, several technical challenges related to the valuation of complex financial instruments remain. These challenges are expected to result in operational headaches for companies from an accounting and risk management perspective during the transitional stage. It is important for businesses to consider taking steps now to identify the technical challenges and key valuation considerations related to specific financial instrument types.
The valuation of floating rate instruments typically entails the use of an income approach where the present value of expected future principal and interest payments is calculated through a discounting mechanism that captures the time value of the cash flows and the risk profile of the underlying borrower. Some derivative instruments, such as interest rate options that are benchmarked to LIBOR, require a different valuation method through option pricing frameworks. Depending on the specific features and embedded options associated with the subject instruments, the valuation framework can vary from a simple discounted cash flow approach to more sophisticated stochastic interest rate models or default models.
With any valuation technique, the reference rate transition from the LIBOR to SOFR will impact various elements within a valuation exercise for floating rate and derivative instruments. Certain key distinctions between LIBOR and SOFR will inevitably alter the dynamics of the future expected cash flows and required consideration of the discount rate associated with the corresponding instruments.
Key Valuation Challenges
The key challenges facing SOFR adoption stems from the inherently different characteristics associated with the two sets of reference rates:
- Market Observation: The LIBOR has a long-established term structure with solid depth and liquidity for various tenors, allowing for the interest rate determination process to be conducted in advance of an interest period. In contrast, SOFR represents an overnight rate where payments are generally compounded in arrears. This results in a situation where both parties within a SOFR-based transaction will not have any foresight on the exact amount of the interest that will be paid. As such, one of the most prominent issues facing SOFR adoption is the lack of a reliable term structure that allows market practitioners to attain forward-looking insights on market expectations of future interest rates. This challenge is partially mitigated through the development of SOFR future and swap markets since May 2018. While these SOFR-based derivatives have not yet gained the same level of depth and liquidity as their LIBOR counterparts, ARRC has repeatedly pointed to the importance of promoting availability and reliability to a SOFR term structure over time. The establishment of forward-looking SOFR term rates is considered by ARRC as “the final step in the Paced Transition Plan” and is exemplified through its recent request for a potential administrator to publish forward-looking SOFR term rates on September 10, 2020.
- Valuation Consideration: Expected interest payments represent a critical cash flow component within a valuation analysis. Traditionally, future LIBOR-based interest payments are estimated using the forward LIBOR curve whereby interest rates are estimated at each future coupon payment reset date. The availability of forward-looking SOFR term rates will greatly enhance the valuation process of floating rate instruments, as it will offer the visibility required for any market practitioner to model out expected future cash flows. Until the SOFR futures and swaps market gets to a sufficient level such that an official forward curve can be established, current market practitioners can only carry out certain approximation approaches through the use of indicative forward-looking term rates as published by the Federal Reserve, and a combination of bootstrapping and extrapolation techniques. While these preliminary model constructs might not produce immediately accurate outcomes with current market inputs that required further regulatory developments, such exercises will allow companies to start acquiring a more comprehensive understanding of the specifications that need to be included on future transition platforms.
- Market Observation: Another issue facing the SOFR adoption process is the difference in the level of credit risk carried by the LIBOR and SOFR. The SOFR is a form of borrowing cost that is collateralized by U.S. Treasury securities and is therefore considered to be a risk-free measurement. On the contrary, the LIBOR represents unsecured interbank borrowing and funding costs and therefore carries an inherent credit risk component. This has led to the different levels of expected rate of return required by market investors on the two underlying sets of reference rates. The spread differential between the LIBOR and SOFR-based contracts (basis) has generally been observed to be in the range of 15bps to 35bps over the past two years, based on 3-month LIBOR and 90-day average SOFR contracts. Among other factors, such a spread differential primarily highlights the difference in market expectations driven by the perceived credit risk associated with each of the underlying reference rates.
- Valuation Consideration: Such differences in the underlying expected rate of return due to credit gives rise to two additional valuation considerations. First, additional compensation will be expected by the party historically receiving LIBOR-linked payments to make up for the risk-free nature associated with SOFR-linked instruments. This challenge will need to be tackled with a focus on the expected cash flows associated with the underlying instruments. Second, market practitioners will need to re-examine the estimation process of the discount rate to account for the different risk profile upon transitioning from a legacy LIBOR instrument to a new SOFR instrument. The current standard industry practice includes a benchmarking zero rate curve (market practitioners often use a spot curve instead as the benchmarking rate for practical expedient), as well as a market credit spread that reflects the risk profile of the borrower. The new practice will require a decomposition of the discount rate build-up process. This leads to additional complexity on the already analytically intensive credit assessment and market risk study that is required as part of the current standard valuation process.
The Road to Facilitating “Value-for-Value” Exchanges During the LIBOR-SOFR Transition
The aforementioned challenges have meaningful implications on the reference rate transition process as a fair valuation approach is required to facilitate a “value-for-value” exchange when fallback provisions are triggered. It is imperative that companies start contemplating these fair value exchange mechanisms to mitigate potential legal, reputational and accounting complications that could arise from a transaction that is deemed favorable to one party and unfair to the other.
It is commonly acknowledged among market practitioners that a spread adjustment process will be required in order to establish fair value equivalence during a LIBOR/SOFR transition. The ARRC initially recommended a determination process based on a historical median over a five-year lookback period where the spread adjustment is calculated using the difference between the LIBOR and SOFR. The ARRC further updated the recommendation through a June 2020 publication, indicating that the ARRC’s recommended spread adjustment matches the spread adjustment methodology suggested by International Swaps and Derivatives Association (ISDA), as detailed in the Rule Book co-authored by ISDA and Bloomberg. The June 2020 publication further included a recommended transition period for certain consumer products.
The use of a historical median and potentially a supplemental transition period for certain consumer products promote convenience and efficiency from an operational standpoint. Nonetheless, as historical data is rarely representative of future performance, this practice might not eliminate potential value transfers during the LIBOR-SOFR transition. Specifically, any unexpected market movements near or at the time of the transition could result in failures to establish fair value equivalence. In fact, the LIBOR/SOFR spread widened significantly in late March and early April 2020 after a spike in the LIBOR rates, before it started gradually moving back to a more “normalized” level. As such, companies should stay abreast of the most recent market trends and develop sufficient flexibility to prepare for any uncertainties associated with the upcoming macroeconomic changes.
While market conditions will continue to evolve from now through the end of 2021, companies should keep in mind that it often takes a considerable amount of time to establish a comprehensive valuation platform that will harmoniously connect with the organization’s overarching investment policy, risk management procedures and internal control process.
Valuation Considerations for Specific Instrument Types
The ARRC has released recommended contractual fallback language for a group of fixed income instruments where the interest rates are typically tied to a benchmark rate. We have included an overview of the valuation techniques that are generally applicable for these instrument types:
- Syndicated Loans
- A syndicated loan is a type of debt financing offered by a group of financial lenders that provides funding to a borrower.
- While the valuation of a syndicated loan technically requires a stochastic interest rate framework to incorporate prepayment options associated with the underlying instrument, market practitioners are usually able to adopt a more simplified valuation model through a discounted cash flow method as an approximation approach. As such, specific considerations related to SOFR adoption for this type of instrument are broadly consistent with the valuation challenges described above.
- Bilateral Business Loans
- A bilateral business loan is funded to a borrower by one particular lender.
- The economic structure of a bilateral business loan is similar to that of a syndicated loan; as such, similar valuation considerations are applicable for bilateral business loans.
- Floating Rate Notes
- Floating rate notes are debt instruments issued in the capital markets, generally with a longer maturity term than that of a syndicated or bilateral business loan.
- The economic structure of a floating rate note is similar to that of a syndicated and bilateral loan. However, due to the longer maturity term associated with the floating rate notes, a valuation exercise will require more rigorous assessment of the term structure of the SOFR for longer tenors.
- Adjustable Rate Mortgages
- Adjustable rate mortgages are a type of mortgage with an interest rate that is tied to a benchmark curve after an initial fixed-rate period.
- Valuation models constructed for this type of instrument usually need to take into consideration the principal amortization schedules. As the underlying borrower and real estate property constitute the level of credit risk associated with the instrument, the discount rate will need to be estimated through a different analytical process than that of the syndicated/business loans and floating rate notes.
- Structured Products
- Structured products represent financial instruments that have undergone a securitization process with cash flows structured into various tranches of priority claims and backed by the underlying pool of assets.
- Valuation techniques often vary depending on the specific type of underlying assets and the complexity of the securitization process. These approaches range from a simpler modified discounted cash flow method that takes into consideration prepayment and default rates to more complex simulation-based default models.
- In connection with the SOFR adoption, fallback language for structured products is expected to include Asset Replacement Percentage Triggers with an intent to mitigate basis risk between the securitized instrument and the underlying assets. This has a meaningful implication on the modeling process, as market practitioners will need to attain an understanding of the percentage of underlying assets that have been converted to an alternative reference rate or replaced by assets bearing an alternative reference rate.
Preparing for Success
The impact of the transition from LIBOR to an alternative reference rate extends beyond a company’s immediate accounting policies; it also has meaningful implications on their overarching investment framework and risk management processes. Gathering input from impacted stakeholders within an entity can help prepare a comprehensive plan of action that covers the various elements of transition readiness. A holistic approach where key stakeholders have their voices heard and cross-functional needs are integrated can help position companies for success.
The MFA Companies has a comprehensive group of risk management, accounting advisory and technical valuation professionals available to assist customers through the LIBOR transition. Please connect with us if you have any questions or concerns regarding your company’s interest rate exposure as part of the LIBOR-SOFR transition process.
 On November 30, 2020, the Federal Reserve announced a plan to potentially postpone the complete phase out of the USD LIBOR until June 2023. While the Fed still urges U.S. banks to stop underwriting new floating rate instruments using LIBOR by the end of 2021, it is expected that the plan could allow the legacy LIBOR instruments to experience a smoother transition as most of them mature before mid-2023.
 “Transition from LIBOR” published by the ARRC. https://www.newyorkfed.org/arrc/sofr-transition
 “ARRC Encourages the Transition Away from LIBOR to SOFR” published by the ARRC on April 22, 2019. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/ARRC-Apr-22-2019-announcement.pdf
 “ARRC Releases Request for Proposals for the Publication of Forward-Looking SOFR Term Rates” published by the ARRC on September 10, 2020. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Press_Release_Term_Rate_RFP.pdf
 “Indicative Forward-Looking SOFR Term Rates” as published by the Federal Reserve. https://www.federalreserve.gov/econres/notes/feds-notes/indicative-forward-looking-sofr-term-rates-20190419.htm
 Source: Bloomberg L.P.
 “ARRC Announces Recommendation of a Spread Adjustment Methodology for Cash Products” published by the ARRC on April 8, 2020. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Spread_Adjustment_Methodology.pdf
 “ARRC Announces Further Details Regarding Its Recommendation of Spread Adjustments for Cash Products” published by the ARRC on June 30, 2020. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2020/ARRC_Recommendation_Spread_Adjustments_Cash_Products_Press_Release.pdf
 “IBOR Fallback Rate Adjustments Rule Book” published by Bloomberg and ISDA on April 22, 2020. https://data.bloomberglp.com/professional/sites/10/IBOR-Fallback-Rate-Adjustments-Rule-Book.pdf
 “Summary of ARRC’s LIBOR Fallback Language” published by the ARRC in November 2019. https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/LIBOR_Fallback_Language_Summary
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