Much has been written about what the elimination of the London Interbank Operating Rate (LIBOR)—the global interest rate benchmark—will mean for the financial sector and the resulting need to reset interest rates on trillions of dollars of financial products. The transition away from LIBOR will also impact businesses outside of the financial services industry, including manufacturing companies, to the extent their trade and financial commitments are pegged to LIBOR.
Manufacturing companies have a variety of direct and indirect exposures to LIBOR, such as term loans and floating rate notes, financial and operating leases, asset-backed financing, supply chain financing, invoice factoring and derivative contracts. Businesses may have late payment penalty clauses in contracts, supply agreements that adjust for volume variances and payment date changes, and even instances where purchase pricing may include an interest component. LIBOR may also be used to calculate fair value of contracts and for capitalization of interest.
Given the various departments, business units and locations that are part of global manufacturing companies’ structure, the direct and indirect exposures can be quite substantial.
If contracts just provide for the latest available LIBOR, then such variable term contracts can effectively become fixed-rate contracts when the LIBOR rates cease to be published. If the method for calculation of LIBOR changes or if lenders have increased costs due to changes in LIBOR, that may translate to potential increases in interest rates to the borrower.
LIBOR alternatives
In March 2021, the elimination of USD LIBOR for overnight and one-, three-, six-, and 12-month rates was pushed to June 30, 2023, providing more time for contracts linked to LIBOR to naturally expire without having to shift them to a new benchmark. However, the phase out for all sterling, euro, Swiss franc and Japanese yen linked LIBORs and USD LIBOR for one-week and two-month rates is still scheduled to be complete by Dec. 31.
Many alternatives have been introduced as an alternative to LIBOR. These alternatives can be credit sensitive or considered risk-free reference rates. RFRs are based on actual overnight lending transactions instead of the estimates or judgments of credit risk that credit sensitive rates are based on.
The more prominent alternatives are Secured Overnight Financing Rate (SOFR) for the U.S. dollar, similarly SONIA for sterling pound, ESTER for euro and TONAR for yen. In the United States, in addition to SOFR as an alternative rate, the Ameribor overnight rate and the Bloomberg Short Term Bank Yield Index (BSBY) are also alternatives.
LIBOR has been an established and widely adopted benchmark for many decades in global trade finance and many companies worldwide include LIBOR as a preferred benchmark in their trade and financial commitments—all of which need to be revised to refer an alternative benchmark such as the SOFR.
Global companies that have intercompany financing arrangements with their foreign affiliates will also need to revise their related party loan and cash pooling agreements. If companies do not revise contracts, or if there are no fallback provisions, there may be conflicts on how payments should be made or delays in the fulfilment of contractual obligations.
These uncertainties may negatively affect borrowing costs, but using SOFR instead could lower interest costs somewhat. This is because SOFR is a secured borrowing rate based on treasury rates, whereas LIBOR is an unsecured rate which has a built-in credit risk component because it represents the borrowing costs by a bank.
Slow transition
Companies have been slow to make the shift for many reasons ranging from concerns with the alternative benchmarks to bankers not making alternative rates accessible. Ford Motor Co. was the first corporate borrower to transition its revolving credit facilities from LIBOR to SOFR.
According to a survey of corporate borrowers conducted by the U.S. Chamber of Commerce with the Association of Financial Professionals and National Association of Corporate Treasurers, more than 60% of respondents indicated that their banks have not offered them SOFR or other non-LIBOR alternatives.
“Inertia has provided to be a powerful disincentive to shifting away from the existing benchmark alignments,” according to an article by Bloomberg analyst Brian Chapatta. “But the risk of contracts unraveling, hedges failing or interest-rate mismatches fracturing commercial arrangements increases as Libor’s endgame gets closer.”
Nevertheless, companies need to have a plan to transition their LIBOR-linked commitments to an alternative rate. Companies that have non-USD LIBOR-linked commitments or a one-week or two-month USD LIBOR commitments, only have until December to prepare for such a change. No bank can help capture all impacted commitments for a company and hence borrowing companies have to take charge. They need to ensure that there are fallback provisions, that their internal and external treasury systems incorporate a new benchmark, initiate discussions and explore opportunities with bankers and suppliers to manage a smooth transition.
Read more global manufacturing insights from Shruti Gupta here.
