July 23, 2020 - While it may be an inconvenient truth, our baseline assumption must be that LIBOR may end in a bit more than 500 days. To help lenders get through LIBOR transition with as little disruption as possible, the ARRC has developed a series of tools – most recently “SOFR Conventions for Syndicated Loans”.
SOFR Conventions for syndicated loans set out a framework for how SOFR loans actually would behave, compute interest, deal with floors and, ultimately, be operationalized. As the Co-Chair of the ARRC’s Business Loan Working Group (“BLWG”), the LSTA was very involved in drafting the conventions. For this reason, we are well positioned to offer an English Language Version of the conventions!
First, these Conventions do not address either Forward Looking Term SOFR or SOFR Compounded in Advance. Because counterparties would know their interest rates in advance of the interest period, these two SOFRs operationalize like today’s LIBOR – and thus their conventions do not need to change markedly. However, for Daily Simple SOFR and Daily Compounded SOFR, the interest rate would not be known at the beginning of the interest period, it must be pulled (and compounded for Daily Compounded SOFR) and built during the interest period. Because you build the rate during the interest period, the conventions for the Daily Simple and Daily Compounded SOFR are very different than for 1M/3M LIBOR.
Step One is how to calculate SOFR (pps.1-2). The Conventions explain that there are, effectively, three methods to create a Daily Compounded SOFR: Compound the Balance, the Cumulative Compounded Rate and the Noncumulative Compounded Rate. The Conventions also offer an, ahem, simpler methodology to calculate Daily Simple SOFR (p. 2). The ARRC will soon be publishing spreadsheet that demonstrates each calculation methodology. Gird yourself…only Simple is simple.
Several other issues affect calculating the rate. For legacy loans that fallback from LIBOR to SOFR upon LIBOR cessation, there will need to be a “spread adjustment” to reduce the value transfer from one party to another (p. 5). For Daily Simple SOFR, the spread adjustment is easy – it is just added to SOFR. However, for Compounded SOFR, SOFR is compounded, but the spread adjustment is not, leading to somewhat more complications in the calculations.
Interest rate floors (pps. 4 and 5) are another consideration (particularly in today’s rate environment!). Interest rate floors are relatively straightforward for new loans originated on SOFR: the floor would be applied daily and would apply only to SOFR. For loans falling back from LIBOR to SOFR, the floor would apply to SOFR+spread adjustment as that is the LIBOR equivalent. This is rather complicated to code for Compounded SOFR (because the floor is applied daily, but will apply to compounded SOFR plus the simple spread adjustment.) For Simple SOFR, the calculations are, once again, simpler.
The final key interest rate point is that while the SOFR Index (p. 4) is a very helpful tool for many products, it may not be as applicable to syndicated loans with their daily interest rate floors, intra-period prepayments and the fact that they trade without accrued interest.
Next, because a “daily” rate determines interest due during the interest period and counterparties do not know the final interest rate until the end of the interest period, Step Two is how to build in enough time to invoice the borrower and allow the borrower to repay interest at the end of the period. The Conventions recommend using a “lookback without observation shift”. A lookback just says to “look back” five days and apply the five-day earlier rate to today. This allows the calculation of interest to start and end five days earlier, and thus gives five days of breathing room to invoice the borrower at the end of the period.
The interest rate considerations and the lookback likely are the most critical (and potentially confusing!) aspects of transitioning to LIBOR. But, in addition to those issues, the Conventions also address a series of relatively straightforward daycount, holiday, weekend and business day conventions.
The ARRC (and the LSTA) hope that laying out these conventions (and providing live examples shortly) will help the loan market conceptualize and operationalize SOFR as the time to LIBOR cessation marches inexorably on.