As interest rates collapsed during the financial crisis of 2008, lenders began incorporating LIBOR (London Inter-bank Offered Rate) floors into credit facilities primarily for non-investment-grade companies. These provisions have also been far more common in European loans as rates there have been negative for several years. (We recently discussed the topic.) The vast majority of U.S. investment-grade facilities, however, have avoided these LIBOR floors.
Now, as 1-month USD LIBOR rates have plummeted over 150bps to 0.17% during the economic shutdown, lenders have been successful in adding these floors to new or amended investment-grade credit facilities.
Borrowers can appreciate the significant economic value of this concession by quantifying the floor in the derivative markets and incorporating that information into their credit facility negotiations. Roughly speaking, a 1% LIBOR floor on a 5-year facility has a present value of over 4%!
For a $1 billion loan, that upfront value is over $40 million — an amount many multiples greater than the upfront lender-fees paid on a typical investment-grade facility. Expressed differently, adding the LIBOR floor is equivalent to increasing the borrowing spread by over 80 bps per annum.
For many investment-grade borrowers, this could double the funding spread on the loan. To be fair, the floor may be less relevant for facilities that are expected to remain undrawn or retired prior to maturity. However, the economic cost, and likely the direct cost, of the floor is very real for borrowers who fund on these facilities.
Tenor and strike are two primary structural factors that drive the value of a LIBOR floor.
The tenor describes the term of the floor. A 5-year is more valuable for the lender and more costly to the borrower than a 1-year floor because the lender retains the protection from lower rates for a longer period of time. The strike is the stated rate under which the borrower does not benefit from declines in LIBOR.
For instance, a 1% floor allows the lender to replace any future LIBOR settings below the floor with the floor itself. The higher the floor, the more valuable the option is for lenders and the more costly it is for borrowers.
The present value calculation of the floor price is based on several market inputs including the LIBOR index, the term structure of interest rates, volatility, and liquidity. To get a better sense of this value, we provide a table below depicting mid-market upfront prices of 1-month LIBOR floors for various tenors and strikes utilizing prevailing market conditions on May 19, 2020.
Tenor 0.0% Strike 0.5 % Strike 0.75% Strike 1.0% strike
1 Year 3 bps 32 bps 54 bps 78 bps
2 Years 11 bps 71 bps 117 bps 164 bps
3 Years 28 bps 114 bps 179 bps 248 bps
4 Years 50 bps 158 bps 240 bps 328 bps
5 Years 75 bps 203 bps 298 bps 403 bps
Interestingly, zero-strike floors have a value even though LIBOR is currently positive. For 1 year, a zero percent floor is worth 3 bps upfront, and, for a 5-year, a zero percent floor is worth 75 bps upfront or over 15 bps per annum. The derivative incorporates the probability-adjusted future value of LIBOR and is not dependent on the actual future path of LIBOR.
Some borrowers might justify adding a zero percent floor on a 1-year facility because of the minimal economic cost of the floor. The issue with that approach is that adding any floor mechanism sets a precedent that makes it easier to raise the floor strike and makes it harder to remove that floor, in the future. Borrowers must also be attentive to the potential accounting implications on the hedges on facilities where the underlying terms are amended or modified.
The prevalence of these LIBOR floors in investment-grade credit facilities is rising quickly in today’s capital markets. Many borrowers might view that LIBOR floor to be a relatively minor concession until they consider the present value of replicating the same loan without the floor. Borrowers understand that there are many important terms and conditions in a loan agreement, and the introduction of the LIBOR floor is one that should be added to the priority list of provisions to be avoided.
David Greenberg ([email protected]) leads EA’s business development efforts and has spent over 25 years structuring and advising corporations on derivative transactions including at JPMorgan and Deutsche Bank. William Kloehn ([email protected]) heads up EA’s derivative practice and brings over 30 years of derivative experience including a decade at a derivative advisory firm and over 20 years at Citibank.