April 15, 2021 - On the Wednesday Ops panel, LIBOR experts addressed the challenge that, by year-end, we’ll be living in a “multirate” world, e.g., there will be loans priced over LIBOR, variations of SOFR and potentially even Credit Sensitive Rates (“CSRs”). They answered the question of “How are we going to manage the transition to the multirate world and, once there, how will we function?”
The panel discussed the rates that could exist in the future and contrasted them to LIBOR (Slide 4 of the presentation). As readers likely know, the leading replacement contender has been SOFR, the “Secured Overnight Financing Rate”. SOFR is a daily rate based off overnightTreasury repo; however, there are ways to create a 30- or 90-day rate, by either using an average of the daily rates or using a SOFR forward curve.
As Slide 4 shows, forward looking Term SOFR and Credit Sensitive Rates are most like LIBOR. They both have a natural term curve (i.e., 1- and 3-month tenors) and are known in advance of the interest period, thus their documentation and operations are very similar to LIBOR. However, an official forward looking Term SOFR is not yet recommended for use, and the CSRs generally are still in development. SOFR Compounded in Advance is calculated by looking back at the previous period (like 30 or 90 days), taking the compound average of the daily SOFR rates, and then locking that rate in at the beginning of the interest period. Because the rate is known “in advance” of the interest period, SOFR Compounded in Advance operationalizes and is documented much like LIBOR. However, because it looks backwards to the previous period, it reportedly can create asset-liability management issues, borrower arbitrage opportunities and temporal basis risk.
Daily Simple SOFR and Daily Compounded SOFR are least like LIBOR because the parties don’t know the interest rate in advance and instead pull the rate daily (and compound it for Compounded SOFR) and calculate the interest rate during the interest period. The final interest rate is not known until the end of the interest period.
So how do these slightly different rates perform? The COW demonstrates how the SOFRs behave in the March 2020 market disruption. Because SOFR in Arrears is calculating the rate on a “live” daily basis, it will begin pulling in the new rates as soon as they move, and hence will react first. Because SOFR in Advance locks the rate from the prior period, it reacts last. Forward Looking Term SOFR reacts only once the interest rates change, and the new rate is applied to interest periods starting that day; thus, Term SOFR’s reaction speed is between SOFR in Arrears and SOFR in Advance.
So which rate “wins”? No one can say yet. Most lenders and borrowers say they want a rate known in advance of the interest period, which would bias the market toward Term SOFR, SOFR Compounded in Advance or a Credit Sensitive Rate. However, some borrowers say they want a cheap perfect hedge, which might bias them toward SOFR in Arrears (with a corresponding SOFR hedge). Moreover, it is clear that we will be living in a multirate environment starting late 2021 because banks must stop originating LIBOR loans (and thus will originate on SOFR or CSR), while legacy loans will still be on LIBOR. Ultimately, the panelists are preparing to live in a world that has LIBOR loans, SOFR loans and potentially CSR loans all at the same time. And they recommend that all market participants prepare for that too.
The LSTA has developed resources to help members prepare. First, there is an entire section of www.lsta.org dedicated to LIBOR transition. Second, the LSTA hosts a Weekly LIBOR Q&A Call on Mondays at 3PM (ET) where we discuss issues that market participants raise. Third, the LSTA has posted a series of helpful Zoomcasts on the LSTA Podcast page. The current set discuss Credit Sensitive Rates, while an earlier set include vendors demonstrating their LIBOR remediation tools.