August 18, 2021 - by Meredith Coffey. As everyone knows, no new USD LIBOR loans or CLOs should be originated after the end of 2021. We have been making material progress toward that deadline; the fact that Term SOFR is now in scope for business loans and CLOs could facilitate the use of SOFR. However, there is a nagging issue: SOFR is a risk-free rate and LIBOR is a credit-risky one, meaning that SOFR generally is lower than LIBOR and thus may require a compensating spread or margin adjustment.
A sticking point in originating new SOFR loans is that market participants are having trouble determining a “fair” spread adjustment to make new SOFR loans economically equivalent to LIBOR loans. While the ARRC fallback spread adjustments (26 bps for 3M contracts and 11 bps for 1M contracts) generally look economically “fair” when compared to a variety of historical periods, the current spot spread between LIBOR and SOFR is lower because interest rates are near zero. The discrepancy between long-term LIBOR-SOFR differentials and the spot spread may be slowing the adoption of replacement rates.
The LSTA think piece considers:
- How LIBOR and SOFR behave in “normal” periods and market disruptions
- Why today’s LIBOR-SOFR spot differential diverges from historical LIBOR-SOFR spread differentials
- What futures markets tell us about where LIBOR and SOFR may – or may not – go
- A purely theoretical consideration of how one might transition from today’s spot spread to a long term economically “fair” adjustment
- The precedents for using a “spread adjustment transition period”
This article is meant to help facilitate data-driven discussions between borrowers and lenders about how spread adjustments might be considered for new SOFR loans. The article is available here; please send questions and/or comments to mcoffey@lsta.org.
