October 14, 2021 - This week, we saw ARRC exhortations to move off LIBOR, more SOFR loans emerge and extensive price discovery around the SOFR credit spread adjustment (“CSA”). (We also hear that many investors have started their CME Term SOFR Licensing process and urge all others to do so!) Let’s drill in.
Last week, JPM launched what we believe was the first Day-One BSL syndicated US institutional SOFR loan: a $600 million TLB for Walker & Dunlop, as reported by Bloomberg. This week, Bloomberg and LCD reported on two additional JPM SOFR deals, one for Traverse Midstream Partners and one for Draslovka Holding.
The spread dynamics of these deals are important; Walker & Dunlop was first reported as SOFR + a flat 10 bps CSA across interest rate tenors + 250 bps margin (SOFR+10+250). In other words, the CSA was flat across one-month, three-month and six-month tenors. This Thursday, LFI, Bloomberg and Refinitiv reported that pricing had been refined to offer a CSA curve – 10 bps for 1M, 15 bps for 3M and 25 bps for 6M.
Some folks have observed that these CSA levels are below the ARRC Recommended Spread Adjustments of 11 bps for 1M LIBOR contracts falling back to 1M SOFR and 26 bps for 3M LIBOR contracts falling back to 3M SOFR. We would note that that might not be the definitive comp. While they are certainly informative datapoints, the ARRC did not mean for their fallback spread adjustments to dictate new issue spreads. On p. 3 of its January 2020 spread adjustment consultation, the ARRC stated that, “It is important to emphasize that any ARRC-recommended spread adjustments are intended for use in LIBOR contracts that have incorporated the ARRC’s recommended hardwired fallback language or for legacy LIBOR contracts in which parties are able to and choose to select an ARRC recommended spread-adjusted rate as a fallback. The recommended spread adjustments would not and are not intended to apply to new contracts referencing SOFR. (emphasis added).”
So how might folks think about credit spread adjustments for SOFR? As we discussed in LSTA publications and podcasts, the issue is sticky because today’s interest rates are near zero. Because rates are so low, today’s LIBOR-SOFR differential is lower than what we’ve seen in the past (ARRC Spread Adjustments) and what we may well see in the future (Forward Looking Basis Swaps). This week’s COW frames that issue, reviewing various 3M LIBOR-3M SOFR spread differentials. The COW compares today’s spot spread differential between 3M LIBOR and 3M SOFR (6.9 bps), the 2Y forward looking 3M LIBOR-SOFR basis swap (14 bps), the Walker & Dunlop 3M CSA (15 bps), the 3Y forward looking 3M LIBOR-SOFR basis swap (17.9 bps) and the ARRC Recommended Fallback spread adjustment for 3M LIBOR-3M SOFR (26 bps). At 15 bps, the Walker CSA is approximately between the 2Y and 3Y LIBOR-SOFR basis swap rates; it is above the spot (which borrowers might prefer) and below the ARRC fallback adjustment (which lenders might prefer).
We acknowledge that figuring out the spread adjustment is far from easy. (Price discovery seldom is!) However, as KKR’s Tal Reback (and co-ARRCist!) noted in Bloomberg, the market eventually figures out where to clear these deals. “That’s very healthy, and that’s why I think ripping the Band-Aid off now in the fourth quarter allows us to understand how that comes together.”