In this second article of a three-part SOFR Series, which includes The Rise of SOFR as an Alternative to LIBOR and Context for SOFR as Rates Shift, the SRS Acquiom loan agency team explores how market participants’ concerns created a pathway for a Term SOFR reference rate, the potential costs associated with the new lending rates, and the inclusion of fallback clauses in legacy loan agreements.
Term SOFR Arrives on the Scene
The transition from LIBOR to SOFR has gone relatively smoothly, surprising some market participants given the trillions of dollars of financial contracts that referenced LIBOR. Regulators largely favored SOFR as a replacement for LIBOR because it is a transaction-based rate determined by borrowings in the highly liquid repo market, which allows for collateralized loans to be repurchased for a specified price at a future date. This active market [GS1] is more reliable than the arbitrary rate-determining process that banks used for LIBOR [GS2] that was not based on actual, overnight trades. Some market participants had misgivings about the alternative rate that was not locked in at the beginning of an interest period and lacked a term structure like its predecessor.
The incorporation of “Term SOFR” was supported by the Alternative Reference Rate Committee (ARRC) and eliminated these key differences between SOFR and LIBOR. The forward-looking nature of Term SOFR aligns with LIBOR in that it uses data from the SOFR futures market to extrapolate projections for future interest payments.
Based upon the supply/demand dynamics of the repo market, SOFR [GS1] is overall a more volatile rate than LIBOR. Taking the compounded average of SOFR over 1-, 3-, and 6-month periods, however, would smooth out any spikes. Various compounding and averaging alternatives exist for reducing SOFR volatility, including SOFR Compounded in Advance and Term SOFR reference rates.
Costs of SOFR and Term SOFR
Since SOFR is a risk-free rate because it is secured by the Treasury market, the curve for 1-, 3-, and 6-month SOFR should be lower and flatter than the respective LIBOR curves. As the Federal Reserve has intimated that rates will continue to rise, SOFR hedging costs are likely to go up. This is a consideration for companies still holding loans tied to LIBOR on their books.
The cost of hedging Term SOFR is one to three basis points higher than a standard SOFR swap. Three reasons drive this difference, to include (1) the newness of the product; (2) the relatively small market size; and, (3) ARRC’s current prohibition on interdealer trading of Term SOFR derivatives.
Term SOFR Is Not Without Challenges
Still, there are a couple of obstacles to overcome. The biggest challenge to date affecting pricing and liquidity is the Term SOFR derivatives trading restrictions under the current rules. These restrictions have precluded the development of a two-way dealer-driven market in Term SOFR. Consequently, banks are hedging their customer-driven Term SOFR swap exposure using daily SOFR. This creates an imperfect hedge and the resulting basis risk is retained on the bank’s balance sheet. This will ultimately have an impact on pricing.
Unable to effectively offload the risk, it continues to accumulate on the balance sheet, potentially leading to market risk-related capital charges that could affect a firm’s appetite to engage in additional Term SOFR transactions. If liquidity in the Term SOFR derivatives market declines, the cost of hedging Term SOFR could increase six to nine basis points more than the standard SOFR swap.
Acknowledging the concerns of the dealer community, ARRC’s term rate task force meets bi-weekly to consider changes to the interdealer trading limitations. These restrictions are likely to be loosened but not eliminated. Regional banks, who are excepted from SOFR derivatives restrictions, are also anxious to centrally clear their SOFR swaps, though this would require an active interdealer market with four to six market makers willing to provide daily mark-to-market quotations and liquidity in the event of default. ARRC’s guidelines do not prohibit the clearing of Term SOFR swaps. However, any relaxation in dealer trading restrictions is unlikely to be sufficient to foster a robust two-way Term SOFR market.
Fallback Clauses and the Adjustable Interest Rate (LIBOR) Act
Another hurdle is phasing out LIBOR in the remaining outstanding loan agreements. There are roughly $15 trillion of “tough legacy” contracts that are not easily amended and do not have fallback provisions for a replacement benchmark to use once LIBOR quotations cease in June. The Adjustable Interest Rate (LIBOR) Act was passed earlier this year to address legacy contracts. It is expected to be implemented before LIBOR sunsets. This legislation provides certainty to market participants with respect to pricing of their LIBOR-based contracts after the June cessation date. Agents selecting a SOFR-based replacement rate ahead of the termination deadline will benefit from safe-harbor provisions.
Lenders and borrowers have sifted through existing credit agreements to implement fallback provisions in loan documents. The ARRC has outlined language to address rate replacements, spread adjustments, and trigger events as they pertain to new contracts.
Specifically for syndicated loans, there are three approaches: (1) the hardwired approach, (2) the amendment approach, and (3) the hedged-loan approach. While the hardwired approach relies upon an agent and borrower agreeing on a replacement rate, the amendment methodology focuses on trigger events and spread adjustments, depending upon the economic impact on lenders or borrowers. Each of these methods may create a mismatch between a loan and a hedge. The third hedged-loan option eliminates the disparity and ensures the hedge and loan match.
Against the economic backdrop of rising interest rates and inflation concerns, questions loom. What will happen should another global financial crisis rear its head? Will floating-rate debt tied to SOFR behave the way LIBOR did during the 2008 financial crisis? How will floating-rate debt respond, and will it accurately adjust to reflect credit risk?
Look for the third and final part in this SOFR series, where our team investigates the ramifications of the alternative benchmarks amid changing market conditions. Please reach out to our team for assistance in understanding these changes and how they can impact your loan portfolio.