Clients often ask us “what is the best option for borrowing with a floating line of credit?” This is becoming an increasingly important decision in light of the current interest rate environment and the options available to borrowers.
In loan agreements, customers can choose different interest rate options – usually either a guaranteed overnight funding rate (SOFR, a reference interest rate) or they can lock in a rate for a period defined. Both options have pros and cons, so it’s important to discuss the various factors before making a decision.
We recently looked at how rising rates have changed variable borrowing options and what would have been the most profitable borrowing rate options for clients over the past year. As expected, during periods of prolonged upward movements in the yield curve, it would have been advantageous to extend the maturities of the rates before sustained changes in the curve were recognized in the market. .
Overnight Reset SOFR, a very common borrowing rate option these days, works a bit differently than what we’ve seen with its predecessor, the London Interbank Offered Rate (LIBOR, the benchmark previous one which is being phased out) to one month. Overnight SOFR tends to follow Federal Reserve rate hikes with minimal volatility between rate hike cycles, largely because one-month futures market expectations of interest rate movements. interest are not factored into the rate as they would be with one-month floating LIBOR.
On average, one-month variable LIBOR was 18 basis points (bps) above overnight SOFR over the past year. At the end of 2021, clients saved an average of 8 basis points in borrowing costs for those switching to overnight SOFR from one-month LIBOR borrowings. An upward adjustment to credit spreads of 10 basis points on SOFR borrowings is usually made when converting from LIBOR.
It is important to re-evaluate borrowing options and conversion structures, which are permitted under loan agreements, and work with advisors to make informed decisions about rate exposure. This includes everything from margin loans, lines of credit on marketable securities, aircraft to commercial real estate. These ongoing decisions can make a significant difference to the bottom line.