May 12, 2022 - We are well into the SOFR era in the US and have nearly completed the UK’s legacy LIBOR loan transition. So where have the regimes aligned, where are there gaps and what are the lessons does the UK transition offer for the US? That was the topic tackled in a presentation at yesterday’s LSTA/LMA Conference.
As slide 3 indicates, the US (SOFR) and the UK (SONIA) have largely transitioned to risk free rates (“RFRs”), rather than credit sensitive rates (“CSRs”). However, the form of the RFRs is very different. The US has broadly adopted Forward Looking Term SOFR, a rate that is documented and operationalized much like LIBOR. In contrast, at the behest of regulators, the UK has adopted SONIA Compounded in Arrears, which must be calculated during the interest period and thus does not permit the parties to know the rate in advance. This has led to significant changes in sterling loan documentation and operations.
Slide 4 dives into LIBOR and SOFR Curves and the issue of Credit Spread Adjustments (“CSAs”). Because it is a risk-free rate, SOFR’s term curve (gold line) will tend to be lower and flatter than the LIBOR curve (green line). This means that loans that shift from LIBOR to SOFR will either need a higher margin or a CSA to remain economically neutral. New issue loans have used a variety of CSAs including a flat 10 bps CSA across the SOFR curve, a CSA curve (10 bps for 1M, 15 bps for 3M, 25 bps for 6M) or, occasionally, the ARRC fallback CSA (11 bps for 1M, 26 bps for 3M, 43 bps for 6M). However, because LIBOR and SOFR are unusually close to each other, the spot difference between LIBOR and SOFR (red bars) is near or below the various CSAs (gold, green and gray bars). This means that it may be cheaper (or not worth the hassle) for borrowers to remain in LIBOR than shift to SOFR. While the US market would benefit from a CSA convention – as discussed later, this is important for some fallback language – UK market participants were free to negotiate the CSA. In many cases, UK parties used the historical five-year median difference between LIBOR and SONIA (which is conceptually similar to the ARRC spread adjustment), while others used a forwards approach (which is conceptually similar to the 10/15/25 bps CSA curve). Regardless, sterling loans have generally transitioned, so this issue is in the rearview mirror. In contrast, the issue of the CSA conventions and economics will impact US legacy loan transition.
And, about that legacy loan transition: The UK has largely gotten on and completed it. (A synthetic sterling LIBOR still exists for “tough legacy” contracts, but most legacy sterling loans have transitioned.) Key lessons from the UK transition: Trailblazers are helpful. (The US has this in droves because we have been originating SOFR loans en masse since January.) Form documents facilitate transition. (The LSTA has a Term SOFR concept loan as well as helpful fallback amendment documents.) Being pragmatic around fallbacks is helpful. (Considering the fights emerging on issues like CSAs and breakage, pragmatism might not be the US word of the day.)
And, critically, don’t leave legacy loan transition to the last minute. Alas, the US market might not heed this advice. Legacy LIBOR loans can transition prior to LIBOR cessation in three ways: Full scale refinancing, a Hardwired Early Opt-In Fallback or an Amendment Early Opt-In Fallback. Unfortunately, the economic situation and the lack of a true CSA convention may make this challenging. The secondary market is soft – average bid on the S&P/LSTA Index sits below 96 – making new issue loans more expensive and opportunistic refinancings less attractive to borrowers. Meanwhile, many CSAs are higher than the spot difference between LIBOR and SOFR; this makes an early-opt in to SOFR uneconomic for many borrowers. And, finally, the lack of a clear market convention for CSAs means that fallback language that pushes agents to use the “evolving or then-prevailing” market convention can be challenging. All this means that borrowers may not want to transition early and, therefore, the US might do most of its legacy loan transitioning near that June 2023 deadline.