We always encourage hedgers to consider the economics of a transaction before looking at the accounting. If the economics don’t make sense, it doesn’t matter how favorable the accounting treatment is, it probably isn’t a good idea!
As reference rate reform transitions from LIBOR to SOFR, FASB has made sure the accounting treatment during the transition will be accommodative; Topic 848 has optional elections to ensure that hedge accounting can continue uninterrupted if the changes to your derivatives and hedged items are reference rate reform related.
- What about the economics of your hedge program? Will the hedge continue to offset changes in the hedged item? Will you still receive predictable results?
- What happens when Topic 848 expires at the end of 2022? At the end of 2022, FASB’s favorable accounting treatment ends. Companies need to prepare for this event ahead of time.
These two questions are somewhat related. Starting with the economics of your hedge program – will your debt and your swap both transition to SOFR? If yes, that’s good, but you are not done yet. Here are some additional considerations:
- Term SOFR (will it be ready in time?)
- Simple average SOFR
- SOFR compounded in arrears
Although ISDA has not yet released their final recommendations for the derivatives market, we believe their fallback language will incorporate SOFR compounded in arrears. Compounding will more accurately reflect the time value of money. This will become more important as interest rates begin to rise. The debt market thus far has favored simple average SOFR (only because term SOFR is not yet available). If your debt is hedged, though, we believe that you will be able to choose SOFR compounded in arrears so that the variable rates on your transactions match. Great, but there is another thing you need to consider - the lock-out period. The lock-out period is generally provided so that there is time to calculate the payment that’s due before the due date. The debt market appears to be leaning toward a 5-day lockout where the swap market convention may be a 2-day lockout. If these differences are not resolved, the economics of the two transactions will be different, however not materially different. It will be advantageous if you can negotiate with your counterparty a lockout period on your debt that matches your derivative.
When Topic 848 expires in 2022, any differences between your derivatives and your debt will need to be taken into consideration for hedge accounting. Fortunately, the different ways of calculating SOFR amounts due, whether it is averaging versus compounding or different lock-out periods, are not expected to generate large differences – particularly if the current low rate environment persists. Those differences may still need to be quantified and included in the effectiveness assessment. If the differences are small enough, we expect that at most you may have to do a one-time analysis or effectiveness assessment to prove out their insignificance.
As always, we recommend lining up the terms as best you can so that interest expense is entirely predictable. Ideally, you will receive the same variable interest on your swap that you pay on your debt (excluding the credit spread on the debt).
We are available with a team of experts to help you identify the LIBOR impact across your company and proactively work with your lenders and/or borrowers to repaper your transactions. We also provide recommended disclosures related to Topic 848 and the steps your company is taking around reference rate reform. Leveraging Hedge Trackers’ experience will save senior management significant time and resources.