October 17, 2019 - On October 1st the LSTA took the next step in its efforts to educate market participants on replacement benchmarks by distributing a draft “concept credit agreement” referencing a compounded average of daily SOFRs calculated in arrears (“Compounded SOFR in Arrears”). The draft was distributed to the LSTA’s Primary Market Committee and the LSTA’s SOFR Working Group for review and feedback, but is available to any LSTA member on the LSTA website. Some of the key points to highlight in the draft are discussed below, but please join us on October 30th for a more fulsome discussion at the Annual Conference “Post-LIBOR Credit Agreements: What Changes and What Stays the Same?” afternoon breakout session.
Why Reference “Compounded SOFR in Arrears”?
As we know, LIBOR is a forward-looking rate so it is known at the beginning of the interest period or “in advance.” By contrast, Compounded SOFR in Arrears is a rate that is not known until toward the end of the interest period. While this is a dramatic shift from the way loans, systems and credit agreements work today, Compounded SOFR in Arrears is the rate referenced by many SOFR floating rate notes, the first cash products to reference SOFR, as well as the designated fallback rate for USD LIBOR derivatives that will be incorporated into ISDA standard definitions next year. Moreover, it is the rate that both gives lenders the time value of money for their loans as well as being the most accurate average SOFR rate because the observation period for the rate more closely matches the interest period for which the rate is being determined. Remember, as the official sector has warned, a forward-looking term SOFR reference rate may not be available by 2021. (For more information on SOFR, please refer to this “U.S. LIBOR Transition: Demystifying SOFR” article.) For these reasons, the LSTA has developed this concept document.
Methodology and Conventions
Any version of “Compounded SOFR” is determined by the calculation, methodology and conventions specified in the contract definition. The definition of “Compounded SOFR” found in the LSTA’s concept document follows the general formula used by the Federal Reserve Bank of NY in publishing its indicative compounded SOFR data and provides for a lookback with observation shift (the length of which is to be determined by the parties). A lookback with observation shift would shift the SOFR observation period so that each rate applies to the repo transaction period it represents (e.g., with a two-day business day shift, the observation period would start and end two business days prior to the interest period start and end dates). The use of an observation shift has a number of advantages: it applies the correct weighting to the daily SOFR rates, it would allow for the use of a published compounded SOFR index, and it is easier to align with hedges that have established the same observation period. While the use of a lookback with observation shift would allow for the use of a published SOFR index, the current definition of “Compounded SOFR” does not provide for the use of such an index because one is not currently available (please refer to footnote 9 in the draft concept document for more information).
Another important point of discussion is with respect to “SOFR floors.” Largely for operational reasons, this concept document provides for a floor in the definition of “SOFR” (i.e., the daily rate that is used in calculating the compounded average of SOFRs) rather than in the definition of “Compounded SOFR” itself. This proposal is informed by conversations in the ARRC Operations WG, but we acknowledge that it would be a change in practice to how floors are applied to LIBOR today and could possibly present challenges if Compounded SOFR is calculated using a SOFR index.
In conversations with market participants, we have heard a general assumption that new SOFR term loans would be structured as simply referencing a SOFR variant plus the applicable margin, and would not include a spread adjustment intended to make the SOFR rate comparable with LIBOR going forward. (Note that this is in contrast to LIBOR-based loans that are falling back to SOFR, where the spread adjustment is designed to make the all-in rate of the loan comparable after the transition.) The concept document was developed on this assumption and no spread adjustment is included. Also, given that SOFR, a broad treasury repo rate, may not be reflective of lenders’ cost of funds, “cost plus funding” (or “match funding”) provisions may no longer be applicable. Those provisions customarily in LIBOR-based loans, such as market disruption and breakfunding, have not been included in the concept document. With respect to breakfunding, it is important to remember not only that match funding is likely not applicable for SOFR-based loans, but also that Compounded SOFR in Arrears is just an compounded daily SOFR rates so it is difficult to translate today’s LIBOR breakfunding provisions into similar provisions for Compounded SOFR in Arrears.
SOFR Fallback Language
If this exercise has taught us anything, it is that nothing is certain. Therefore, the concept document includes robust fallback language if Compounded SOFR in Arrears would no longer be available as a reference benchmark. In drafting this fallback language, we have modified the ARRC’s recommended “amendment approach” fallback language to apply its streamlined amendment process to a future transition away from SOFR.
As our members undertake their review, readers are encouraged to keep in mind that this concept document does not purport to represent or set any standard market practice. It has been developed simply as a tool to further familiarize market participants with replacement benchmark alternatives, in this case Compounded SOFR in Arrears, which will hopefully further assist each institution with its own transition planning. As noted above, the concept document will be discussed in detail at the Annual Conference on October 30th, but we welcome any member feedback before then.
For your ease of reference, please find here a blackline against the draft LIBOR-based investment grade term loan recently circulated to the Primary Market Committee which shows the cumulative changes made to convert a LIBOR-referencing term loan credit agreement into one referencing Compounded SOFR in Arrears. After the Annual Conference we will consider the feedback received and then publish this concept document in “final form.” In the interim, please do not hesitate to reach out to Bridget Marsh or Tess Virmani with any questions.