August 2, 2019 - As the nearby story reports, we are quite excited to see a new CLO with “hardwired” LIBOR fallback language.  (Hardwired fallback language is what is being used in FRNs, and generally states that, upon LIBOR cessation, the contract falls back to a version of SOFR plus a compensating spread adjustment.) 

Edifying CLO news notwithstanding, we keep hearing the question, mostly from journalists, “But when syndicated loans will begin using ‘hardwired’ LIBOR fallback language?” When we canvassed our market participants about when U.S. dollar (not multicurrency) loans could use a hardwired fallback, they generally have flagged two major issues. First, there needs to be more clarity around the look and feel of SOFR and, importantly, its adjustment. (Spoiler 1: One can be observed today, the other will be available around year-end 2019.) Second, there needs to be certainty that loan systems will be able to consume SOFR (and calculate Compounded SOFR) at LIBOR cessation. (Spoiler 2: This is being worked on assiduously.)

First, it’s important to understand that LIBOR will not cease until the end of 2021 – but also may not last much longer thereafter. The U.K.’s Financial Conduct Authority (“FCA”) has stated that it will compel banks to submit LIBOR until the end of 2021. However, in a recent speech, Andrew Bailey, the CEO of the FCA, said they expect bank departures from LIBOR panels at end-2021, and the base case assumption should be “no LIBOR publication after end-2021.” 

Vendors are well aware of the drop dead date and are working rapidly to revamp systems well before it. This work is ongoing under the auspices of the ARRC and its Business Loans Working Group; it was discussed in detail at the ARRC Vendor Workshop on June 28, 2019. Market participants should realize that systems are moving forward and will be prepared for all versions of SOFR. (See this article, which explains the pros and cons of SOFR variants.)

While vendors are upgrading systems, it behooves market participants to become more familiar with SOFR, itself. This is easier than you think! The Federal Reserve is publishing both Compounded SOFR and indicative Forward Looking Term SOFR on this website.

While some folks suggest they may wait until official Term SOFR emerges to do anything, we’ve heard an increasing number of investors acknowledge that SOFR Compounded in Arrears has its benefits. First, it is visible today and executable as soon as systems are ready. Second, it reduces basis risk between CLO assets and liabilities (see here). And, it’s getting much more transparent. ISDA had two notable announcements this week. On Tuesday, ISDA released the preliminary results of its U.S. dollar LIBOR consultation. As expected, U.S. dollar LIBOR derivatives contracts almost definitely will fall back to SOFR Compounded in Arrears and will use the “historical mean/median” spread adjustment. On Wednesday, ISDA announced that Bloomberg was selected as the fallback spread adjustment vendor. Moreover, ISDA has previously commented that the spread adjustment should begin being published around year-end 2019. So, to conclude: First, from a rate visibility perspective, both Compounded SOFR and the spread adjustment will be completely transparent and trackable around year end 2019. Second, from an operations perspective, vendors are working hard updating their systems to consume and compound SOFR.  This suggests that some of the roadblocks to hardwired loan fallbacks might be falling themselves.