Uncertainty around interest rate rises has not yet added significant complexity to the transition from LIBOR pricing, but experts warn of the impact of further rate increases.

According to a recent report from Coalition Greenwich, the combination of interest rate hikes and the move away from LIBOR pricing has the potential to create anomalies in commercial loans over the coming months.

Assistant Director Financial Advisory at Deloitte, Svenja Schumacher, acknowledges that the ability to forecast interest payments due to the backward-looking nature of risk free rates has become more difficult.

“For example, if someone took out a loan on £6m LIBOR beginning December 2021, they would know in December already how much interest would be due in May 2022,” she says. “A loan on SONIA, in comparison, would have already captured the two interest rate hikes from December and February through higher daily rates, which are compounded to make up the final rate.”

This also leaves the borrower with further uncertainty with regards to the March and April Monetary Policy Committee meetings, which could increase the rate further.

Given the lack of experience of how SOFR or other risk free rates behave in a hiking cycle, borrowers still trying to get their heads around how the new rates will be impacted by rising interest rates, says Ulrich Lotze, Head of Risk & Platforms Financing Risk at Standard Chartered.

“Asian banks are still calibrating how to accurately measure funding costs and how to translate that into liquidity premia for floating term pricing,” he adds.

On the upside, the yield curve for most currencies was flat in 2021 and this meant that differences between forward looking term rates and overnight compounded rates were minimal, explains Shankar Mukherjee, UK Ibor Leader at EY.

It should also be noted that communication from the Bank of England on the use of SONIA compounded in arrears statedthat ‘calculating interest on a compounded basis reduces the contribution of ‘one-off’ volatility in interest rates that may occur due to unusual supply and demand factors affecting a benchmark rate on a particular day’ observes Stephen Farrell, Audit & Assurance Partner at Deloitte.

Another benefit of the risk free rates is that they tend to reflect the central bank’s actions more effectively.

“When the Bank of England cut interest rates at the beginning of the pandemic in 2020, SONIA perfectly followed those rate decreases whereas LIBOR – whilst following those movements initially – developed in the other direction,” says Schumacher.

Whilst both indices generally reflect the underlying development of interest rates, LIBOR also includes an implicit credit premium for the banking sector which can increase significantly in times of market stress.

The lack of historical data around the behaviour of the new risk free rates has been a key challenge in pricing, model development and validation. In the face of this, various proxy methodologies have been used and their performance will be tested as we enter a more volatile interest rate environment.

“Of course, the new risk free rates are designed to be different since they do not have a credit component, so how they perform particularly in stress periods will be interesting and a key input into product pricing and model refinement,” agrees Mukherjee. “However, a steeper yield curve environment going into USD transition over 2022 and 2023 means there may be additional challenges.”

Schumacher concludes that it is important to keep in mind that Libor was discontinued in the first place because of market manipulation “so having a benchmark which is underpinned by actual transactions is an overall positive outcome for all market participants.”