SOFR Transition Progresses Despite Market Volatility | White & Case srl
Key points to remember
Almost all new activity in the US leveraged loan market has moved from LIBOR to the new SOFR benchmark
The Alternative Reference Rates Committee’s approval of the SOFR term in 2021 provided a solid foundation for this transition
Attention now turns to how legacy LIBOR-linked loans will handle the move to SOFR
In 2021, after months of regulatory pressure to end reliance on the London Interbank Offered Rate (LIBOR), concerns were growing that the US leveraged loan market was too slow to adopt the funding rate. Guaranteed Overnight (SOFR) as a new benchmark for pricing. loans.
However, much to the relief of regulators, lenders and borrowers have managed the transition with minimal disruption. Fears that the market may not be ready to meet the January 2022 deadline for regulated US banks to stop using LIBOR on new loans have not materialized.
The success of the transition can be attributed in large part to the endorsement of Term SOFR by the Alternative Reference Rates Committee (ARRC), a group convened by the Federal Reserve Board and the New York Fed to guide the transition from LIBOR to United States.
Prior to this approval, the US lending market had shown little enthusiasm for moving to SOFR. While LIBOR is a forward-looking rate known in advance for a given interest period (or term), SOFR is inherently a backward-looking rate, based on overnight transactions in the repo market for US Treasury. Therefore, the amount of interest due on a daily SOFR-linked loan can only be known on or near the payment date.
Since the US lending market had relied on LIBOR for decades, market participants were accustomed to knowing in advance the interest rate that would apply to their loan at regular intervals, and documentation of the loan was structured accordingly. Moving to a retrospective “overdue” rate such as SOFR would have required substantial changes in loan document covenants and operational systems.
However, SOFR futures uses data from the SOFR futures market to generate a forward-looking rate that reflects market expectations of the path of SOFR. This rate works much like LIBOR, giving parties certainty about the interest rate that will apply for the chosen term, and fits into LIBOR-based loan documentation with relative ease. It is now the dominant benchmark in the US lending market, with Debtwire Par estimating that by the end of April 2022, around 96% of recently issued loans had adopted SOFR.
To further facilitate the transition, the Loan Syndications and Trading Association (LSTA) has published a Model SOFR Term Credit Agreement containing defined terms and operational provisions for the SOFR term, which has been adopted by many market participants. in the interest of using a single, consistent approach.
Forward and backward
Debtwire Par estimates that by the end of April 2022, approximately 96% of recently originated loans had adopted SOFR
While the move to SOFR for new loans has proceeded as planned, new issuance represents only a small portion of the overall loan market. There are still a large number of LIBOR-based loans that have yet to transition to the new benchmark.
Although US dollar LIBOR can no longer be used for new loans funded by US regulated banks (and many unregulated institutions have adopted policies supporting this approach), the most popular tenors of the rate are still published and can be used for loans funded before 2022. However, by June 2023, all US dollar LIBOR maturities will be removed and a new benchmark must apply to all loans still using LIBOR. The documentation for most of these loans will include some variation of fallback language, allowing parties to agree on what basis a LIBOR-linked loan will switch to an alternative benchmark.
The two main categories of fallback language are the amendment approach and the hardwired approach.
Under the modification approach, the loan officer and the borrower can agree on a rate to replace LIBOR and related mechanisms. “Required” or “majority” lenders are generally granted a negative consent right, and if they do not object to the change within a specified period, the rate change becomes effective.
The hard-wired approach, on the other hand, specifies the choice of replacement rate in advance (usually based on a cascade of possibilities beginning with the SOFR term) and typically uses the gap adjustment values recommended by the ARRC.
Since the replacement rate and margin adjustment are fixed in advance, the hardwired approach does not require any further consent from the lenders. However, despite a common misconception in the market, the presence of a hardwired fallback language alone is not enough to implement the LIBOR replacement. A number of technical, administrative and operational changes must be made to the loan agreement in order to implement the replacement rate, which means that an addendum (usually signed by the agent and the borrower without the consent from the lender) will still need to be completed. even when hardwired fallback is used.
Tackling these details and formulating a clear transition strategy will be key to getting past the June 2023 LIBOR shutdown deadline for pre-2022 loans with minimal disruption.
Developments around the application of credit spread adjustments (CSA) to SOFR loans are also high on the list of transition priorities.
CSAs are used to bridge the gap between LIBOR and SOFR when pricing a loan with a margin that is not otherwise adjusted. LIBOR is a forward-looking unsecured rate that takes counterparty credit risk into account and has therefore historically tracked higher than SOFR, which is a look-back secured rate that has no element of credit risk. For any lender switching from LIBOR to SOFR on a loan with the same pricing margin, the result is that the lender would likely receive a lower overall return without the application of a CSA.
For legacy LIBOR loans that include ARRC hardwired fallback language, fixed CSAs will apply, based on the historical difference between USD LIBOR and SOFR over a five-year period prior to March 2021 (when LIBOR termination dates have been officially announced). These CSA values are approximately 11.4 basis points (bps) for one-month interest periods, 26.2 bps for three-month interest periods and 42.8 bps for interest periods. six months interest.
There has been notable variation around CSAs on new loans in 2022, however, as this is usually a negotiated point between borrowers and lenders. So far this year, publicly available data indicates that the CSAs on most new SOFR loans are lower than the fixed CSAs recommended by the ARRC, with either a CSA scale of 10/15/25 basis points for a month, three month and six month interest periods, or a fixed CSA of 10 basis points for all interest periods being the most common. There has also been a growing number of transactions where borrowers have received SOFR loan prices without any discernible CSA or margin adjustment.
For borrowers with pre-2022 debt that can be converted to SOFR at ARRC-recommended CSA rates under a wired adjustment, this means the market for a new loan could be more favorable (although, of course, other broader market considerations may weigh against this approach).
As a result, some borrowers may delay switching to SOFR to assess whether a broader modification and/or refinancing transaction might allow them to obtain better overall pricing. But the edge of the abyss is approaching – all agreements must be changed before June next year.
The longer market participants play this waiting game, the greater the risk of a transition bottleneck.