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SOFR Loans Are Here: What You Need to Know Now

  • By By Joyce Frost
  • Published: 1/10/2022
LIBOR in 2022

The first thing to know is that SOFR is pronounced like "gopher" and not "so far," but as we kick off 2022, so far, so good.

The transition away from LIBOR has been a coordinated global effort, not just affecting USD LIBOR but most IBORs around the world including sterling LIBOR, yen LIBOR and euro LIBOR, among others. In most jurisdictions, the regulatory body, such as a central bank or a committee appointed by the regulatory body, e.g., the U.S. Federal Reserve's appointed Alternative Reference Rates Committee (ARRC), has agreed on and recommended replacing the LIBOR benchmarks, which are unsecured rates, with risk-free rate benchmarks. Without diving into the weeds, the regulators concluded years ago that the London Interbank Market — where banks borrow and lend to each other on an unsecured basis — is not deep enough to have trillions of dollars of financial instruments tied to a benchmark that fifteen-panel banks determine at their discretion and is subject to manipulation such as we saw in the "LIBOR Scandal" in 2012.

For USD LIBOR, the ARRC has recommended the Secured Overnight Financing Rate (SOFR) as LIBOR's replacement. SOFR measures the cost of overnight borrowing collateralized by U.S. Treasuries — broadly speaking, SOFR reflects the rates in the overnight repo market. The repo market isn't limited to banks, and transactions, averaging over $800 billion a day, represent a vast body of participants. As a result, the repo market is far more robust than the interbank market and is not subject to private sector manipulation.

The dates you need to know

January 1, 2022: On November 30, 2020, the Federal Reserve, FDIC and OCC issued a joint statement that banks should cease entering into new USD LIBOR contracts after December 31, 2021. New contracts include USD LIBOR debt and new derivative transactions. Note that non-regulated alternative lenders, a large and growing source of corporate loans, may not be subject to the same restrictions. 

June 30, 2023: On March 5, 2021, the U.K. Financial Conduct Authority (FCA), which has oversight over LIBOR's administrator, made a formal announcement that LIBOR rates will no longer be representative after June 30, 2023. Additionally, the FCA will no longer compel the fifteen-panel banks to provide their LIBOR quotes to the administrator.

What comes next

Although there is no single benchmark mandate by the regulators, SOFR-based loans have become the preference of ARRC and most bank lenders in the market. SOFR-based loans are not new to the market with the first SOFR issuances launched in 2018, primarily by government agencies and a handful of banks to test investor appetite and increase liquidity for the new index. There were very few SOFR-based corporate loan facilities in those early years (e.g., Royal Dutch Shell in 2019). Corporate volume finally picked up the summer of 2021, following the regulators' November 30, 2020, announcement, and momentum increased after the ARRC formally recommended forward-looking Term SOFR* rates on July 29, 2021. Since September 2021, Riverside has tracked 15 public market issuers representing over $42 billion of SOFR-based revolver and term-loan transactions, and has directly advised on more than a dozen private market SOFR-based loans.

SOFR spread adjustments

LIBOR is an unsecured term rate (e.g., 30-, 90-, 180-day rate), while SOFR is an overnight secured rate. An unsecured rate is typically higher than a secured rate, and the market at large wanted to avoid value transfer between two parties when replacing LIBOR with SOFR in financial commitments. Therefore, the credit spread to LIBOR before the transition should approximate the all-in credit spread to SOFR after the transition over time:

LIBOR + Credit Spread = SOFR + Spread Adjustment + Credit Spread

Upon broad market consultation by ISDA and the ARRC on an appropriate methodology, the spread adjustments to SOFR for derivatives were determined based on the five-year historical median difference between SOFR and the relevant term LIBOR rate. Any term LIBOR rate (e.g., 3-month LIBOR in a swap) would be replaced by daily compounded SOFR plus spread adjustment. The ARRC’s recommended spread adjustments mirrored ISDA’s, even though a term LIBOR rate in a loan facility may be replaced by a term, not daily, SOFR rate.  

The spread adjustments were set permanently on March 5, 2021, since the FCA announcement was determined to be a Benchmark [Transition] Event, a defined term in ISDA and the ARRC's recommended language for LIBOR fallback provisions in loan and derivative contracts.

  • • 1-month LIBOR = SOFR + 0.11448%
  • • 3-month LIBOR = SOFR + 0.26161%
  • • 6-month LIBOR = SOFR + 0.42826%

Are the spread adjustments in loans negotiable? 

Yes and no. The spread adjustments were only contemplated for use in those loans or financial instruments that contractually incorporate “the spread adjustment selected or recommended by the Relevant Governmental Body for the replacement of the tenor of USD LIBOR with a SOFR-based rate having approximately the same length as the interest payment period.” If your legacy loan contract incorporates ARRC language, the spread adjustments may be contractually set with a few detailed caveats. For derivative contracts, ISDA definitions, although worded differently, have the same effect of incorporating the fixed adjustments. 

On a positive note, I can attest with first-hand experience, that for new SOFR-based loans, the answer is yes! There is much misinformation about the intended use of the spread adjustments, and the statement from the ARRC, and reiterated by officials from time to time, make it clear.  

In its January 2020 Spread Adjustment Consultation, the ARRC made it clear: “The recommended spread adjustments would not and are not intended to apply to new contracts referencing SOFR.”

The SEC-filed documents revealed much when Ford Motor came to market in September 2021 with its much-anticipated, broadly syndicated, global multi-currency facility. So naturally, I was excited flipping through the broad details. However, I finally found what I was looking for tucked away back in the Schedules: Spread Adjustments! Sadly, they were redacted, but that answered my question and confirmed my own experience: yes, the adjustments are negotiable — otherwise, why would they be censored? 

I firmly believe that supply and demand between borrower and lender(s) will dictate the ultimate spread adjustments to SOFR in the short-run. The two-step approach in the market of incorporating a spread adjustment to SOFR to achieve an all-in credit spread to the benchmark should be temporary, and for new loans, ideally should be ignored. Additionally, borrowers always enjoyed the value of the “chooser” option in loan agreements, applying the same credit spread to one-, three-, or six-month term LIBOR. There is a loss of value to the borrower by differentiating the all-in credit spread based on SOFR’s tenor (and multi-currency facilities take the concept one step further). Differentiating spreads also add complexity for the treasury team, which may result in material increased interest cost.

In conclusion, SOFR loans are here to stay and the spread adjustments, which should be temporary in the market, are negotiable. Effective negotiation includes referencing shortfalls in the methodology behind the loan spread adjustments, the current rate environment for LIBOR versus SOFR, market comparables, value transfer and other highly supportive commercial factors, including your bank relationship. We are in the beginning of a new era in the financial markets, and although there will undoubtedly be hiccups, so far, so good. 

Joyce Frost is co-founder of Riverside Risk Advisors, an independent derivatives advisory firm, where she leads Riverside’s LIBOR transition efforts with its clients. She has given dozens of webcasts on the topic since 2018, and has been a featured panelist in numerous industry events including ARRC’s recent SOFR Symposium. Frost is also very active within ARRC as a member ARRC’s Bilateral Business Loan and Non-Financial Corporate Working Groups, the Accounting and Tax Working Group and Conforming Changes, Tax and Term SOFR sub-committees. Riverside is as also a member of ISDA and the LSTA.


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