Estimated reading time: 6 minutes
The article in brief:
- Adoption of LIBOR alternatives is in full swing among private loan market participants.
- SOFR has emerged as the heir apparent to LIBOR in the U.S., but it has some key differences in its maturity and credit profile that must be considered.
- While the regulated bank-led broadly syndicated loan markets are fully underwriting SOFR-based loans, private credit lenders are still feeling their way around and are slowly negotiating some aspects of the switch bilaterally with existing and new borrowers.
Private credit market participants are gradually coming to grips with the phase-out of LIBOR as the key base rate for floating interest rate contracts used in credit and derivatives markets around the world and embracing various successors. In the U.S., private market lenders are following the Federal Reserve-sponsored Alternative Reference Rate Committee (ARRC) and embracing the Secured Overnight Fund Rate (SOFR). Still, several kinks—including credit spread adjustments (CSAs) to these new base rates given lower levels vs. LIBOR and the development of term structure for LIBOR’s heirs—remain to be worked out before the transition is complete.
Ultimately, the switch is an economic “zero-sum” game, i.e., neither the borrower nor lender benefits from the switch from LIBOR to SOFR. Also, a SOFR-based futures float-to-fixed term swap market needs to develop for proper hedging and management of interest rate risk.
While there is still some uncertainty about its replacements, one thing is clear: LIBOR’s days as the leading benchmark for variable interest rate lending are numbered.
For decades the London Interbank Offered Rate (LIBOR), which was based on indicative quotes from roughly a dozen-and-a-half leading banks for borrowing from one another in various currencies on an unsecured basis, served as the most commonly used baseline floating rate for both publicly syndicated and privately negotiated loans around the world.
However, after a 2012 manipulation scandal that led to the conviction of several traders involved in the LIBOR fixing process, regulators worldwide began pushing for the adoption of new benchmarks that were based purely on market forces vs. subjective quotes. Accordingly, regulators have set a number of deadlines for LIBOR’s last hurrah:
- Starting Jan. 1, 2022, all new loan credit agreements in the U.S. dollar, euro, Swiss franc, and Japanese yen will need to factor in an alternative reference lending rate to replace LIBOR.
- Overnight, one-month, three-month, six-month, and 12-month LIBOR will continue to be published until June 30, 2023.
- By the end of June 2023, LIBOR will fully cease to exist as a benchmark. Effectively, any credit agreement that has a maturity past June 30, 2023, will need to have an alternate reference rate defined as an alternative to LIBOR
In general, regulators and industry groups worldwide have been encouraging the use of secured overnight lending rates based on actual high-volume transactions to replace LIBOR in various currencies. However, this is still a work in progress, especially in Europe, where Euribor and the Euro Short-Term Rate are both being used in certain circumstances.
Challenges of SOFR: Term Structure & Credit Component
The SOFR benchmark that has been embraced in the U.S. is based on loans in the repo market collateralized by Treasury securities. Thus, SOFR is an overnight rate, unlike USD LIBOR, which has historically been quoted in maturities ranging from one day to 12 months (with one- and three-month LIBOR as the most common benchmark and interest payment period used in the private credit markets).
CME Group has begun publishing longer-term SOFR rates in one-, three-, six, and 12-month tenors. The most popular three-month term SOFR used in most corporate loan contracts is derived from its daily, one- and three-month SOFR futures contracts. However, trading in these contracts has been thin, and term SOFR still materially weighs in daily forward contracts, given there are still limited volumes for longer-term SOFR contracts. Accordingly, three-month term SOFR is about 25 basis points below the equivalent three-month term LIBOR (70 basis points vs. 95 basis points at the time of this writing).
Another issue is that SOFR has a differing credit profile from LIBOR because it is collateralized by risk-free Treasuries. In contrast, LIBOR has a credit risk component built in, as it’s backed by the International banks that set the LIBOR rates. Not only does that result in a generally lower absolute rate due to the relatively lower credit risk, but market participants should be mindful that SOFR can be expected to behave very differently in times of market stress. While LIBOR increases during major dislocations, since it is based on the creditworthiness of the banks that set the rate, SOFR rates are likely to go down in periods of market volatility as the government securities collateralizing the loans are bid up by investors in a flight to quality.
Practical Adoption in the U.S. Private Loan Market
For older loans originated before 2022, market participants are typically planning to wait for loan resets to make the switch. In cases where existing loan documents don’t provide a contingency for LIBOR going away, they are reopening the documents and adding at least the SOFR fallback rate language.
For new deal activity in the first quarter, U.S. private credit market participants indicate that they see a mix of LIBOR/SOFR primary market deals depending on the sponsor and members of the lending “Club.” It appears most of the new SOFR-based deals are larger-sized deals, where credit spreads appear to be similar or the same as LIBOR-based deals, with a similar SOFR floor of 0.75% to 1.00% (~50 to 75 basis points on larger deals).
However, because of the difference in maturities and credit profiles, and thus, the difference in rates between SOFR and LIBOR, private lenders are generally applying a CSA to SOFR to better match higher LIBOR. But in practice, there is not yet broad agreement on what the spread should be.
In switching to SOFR, the amount of the CSA is ultimately subject to negotiation between lender and borrower, which is often a private equity firm. The Fed’s ARRC has published a recommended spread adjustment for various terms (based on the historical five-year median difference between LIBOR and SOFR). Still, many participants indicated that they are pushing back on using the published ARRC spreads (~11 basis points for one-month SOFR, ~26 basis points for three-month SOFR, and ~43 basis points for six-month SOFR). Instead, they usually negotiate their own lower CSAs, typically 10, 15, and 25 basis points for one-month, three-month, and six-month term loans, respectively. For reference, the current forward daily SOFR curve versus the forward three-month LIBOR curve appears to show about a 20-25 basis point separation due to the Term and credit differences.
Moreover, in a minority of deals, some sponsors are pushing for no CSA where the lender tries to incorporate the lower SOFR into a higher contractual credit spread.
Nevertheless, as luck would have it, in most cases, nearer-term conflicts over lower SOFR versus LIBOR have been avoided to date because the floating portion of many loan coupons are at their preset LIBOR or SOFR floors, which are higher than current SOFR plus the CSA (three-month: 70 basis points SOFR + 15 basis points CSA) or LIBOR (three-month: 95 basis points). But this grace period is expected to end quickly as the Fed follows through on its plans to continue to take short-term rates higher (25 basis points increase in mid-March; three or four more expected 25 basis points increases this year). Both SOFR and LIBOR forward curves and respective swap rates indicate that base rates will fly past base rate floors sometime this summer when SOFR + CSA and LIBOR differences will come more into play.
However, given the current increased trading of forward Term SOFR contracts, it is expected that Term SOFR and Term LIBOR base rates will move to be more in line later this year. Although, Term SOFR may always sit modestly below equivalent Term LIBOR as it is truly a risk-free rate compared to LIBOR. Nevertheless, it is expected that market participants will soon begin to eliminate or roll up the CSA spread into the overall credit spread of a deal instead of treating it as a stand-alone variable. Most are talking about later in 2022 for this to occur.
Summary: SOFR, So Good
The transition from a reference floating rate benchmark that has been around for decades and serves as the reference for trillions of dollars in public and private securities and derivatives contracts is going about as smoothly as expected. However, the transition will continue present challenges for private lenders and their operating and valuation teams as long as loan portfolios have a mix of LIBOR- and SOFR-based deals and as long as there are numerical differences between Term SOFR and Term LIBOR.
Soon to be featured in Business Valuation Update, May 2022.