August 20, 2020 - Last week, we flagged that LIBOR floors were back in a big way in the institutional loan market. This week, Refinitiv posted a chart that made our point more forcefully by looking at the level of LIBOR floors. As their chart demonstrates, 68% of loans had a 1% LIBOR floor and 15% had a 0-75 bps LIBOR floor. In earlier eras, a number of LIBOR floors topped 1%.
Why are have we returned to this topic? Because, remarkably, it i) demonstrates why a “SOFR Index” may be less applicable for loans than for other asset classes and ii) points us toward Simple SOFR. If we do not have a forward looking term SOFR, the loan market may fall back to a Daily SOFR rate which means pulling overnight SOFR and multiplying that by the outstanding principal or balance of a loan. Because one is accruing interest daily (and loan funds are striking daily NAVs, which include daily interest accruals), the interest rate floor must also be applied to SOFR daily.
Why do you care, you ask? Daily Compounded SOFR is complicated for loans – you don’t merely pull the rate daily, but also have to compound it – and may not play nicely with corporate treasury systems. To resolve that problem, some have said that a SOFR Index could simplify the compounding calculations for corporate counterparties. But here’s the rub: A SOFR Index would not be compatible with rate floors. The Index calculates the compounded SOFR rate, which is measured by the Index level. The weighted ratio between two days’ Index levels will give that period’s compounded rate. However, if one of those days has a SOFR rate below a floor, the floor would be triggered. The floor would not be captured in the Index and therefore the Index ratio approach would calculate the wrong interest rate for the period. There has been some discussion about building SOFR Indices with set floors – like zero – but this becomes less workable in a market that uses multiple floors.
In contrast, the Daily Simple SOFR calculation is more straightforward; we are told it works easily in corporate treasury systems – it operationalizes like daily LIBOR or Prime – and thus doesn’t require an Index to simplify the process. So, believe it or not, there are less than six degrees of separation between the LIBOR floor revival and Daily Simple SOFR.