August 25, 2021 - by Meredith Coffey. US regulators have clearly said – and reiterated as recently as August 23, 2021 – that the loan market must start originating loans on reference rates other than LIBOR. These potential USD replacement rates likely are either SOFR or a credit sensitive rate. Because SOFR is a risk free rate – and hence lower than LIBOR – one issue is what “spread adjustment” might be applicable. We discussed these issues on a recent zoomcast and highlight key issues below.
As everyone likely knows, LIBOR embeds a measure of credit risk, while SOFR is nearly risk free. This means that historically SOFR has been lower than LIBOR. To minimize value transfer, the ARRC recommended that contracts that fall back from LIBOR to SOFR use a spread adjustment of 26 bps for 3M contracts and 11 bps for 1M contracts. While the ARRC recommended spread adjustments are consistent with historical observations, today’sLIBOR-SOFR spot differential is very low because interest rates are close to zero.
In the zoomcast, we analyze the historical LIBOR-SOFR spread data, the current spot spread and what futures markets tell us about where the rates might be going in the next few years. We then flag possible ways to think about spread adjustments. Note that this presentation only pertains SOFR loans; the LSTA also has developed tools for credit sensitive rates but they are not covered here. The presentation is available here; a related SOFR Spread “Think Piece” is available here.