September 8, 2021 - by Meredith Coffey. As we discussed in the recent “LSTA SOFR Spread Think Piece” and “LIBOR-SOFR Spread Adjustment” podcast, the historical (and likely future) difference between LIBOR and SOFR is much wider than the current “LIBOR-SOFR spot spread”. For instance, the ARRC recommended spread adjustment is 26 bps for 3M hardwired LIBOR loans that fall back to 3M SOFR at LIBOR cessation. This ARRC spread is aligned with 5-, 10-, 15- and 20-year historical observations, as well as what the futures markets predict. However, because interest rates are hovering near zero, the “spot” difference between 3M LIBOR and 3M SOFR in early September 2021 is seven bps.
This gap between where the LIBOR-SOFR spread “should” be and where it actually is may create a conundrum as parties think about spread adjustments on new SOFR loans. As discussed in our podcast, there may be several issues to consider: First, is the new all-in loan rate economically neutral – i.e., are both parties in the same economic position in the long term? Second, are spread adjustments operationally unwieldy and/or could they create additional secondary market complexity. The LSTA reviewed four potential approaches to spread adjustments on new SOFR loans and considered strengths and weaknesses of each.
Option One: Lock in the spot or a negotiated static spread adjustment – which would be separate and in addition to the loan margin – at SOFR loan origination.
- Example: LIBOR+300 bps à SOFR + spot/negotiated spread adjustment + 300 bps
- Strengths: Because the spot spread is lower than the long-term LIBOR-SOFR differential, this approach encourages borrowers to originate new SOFR loans (which banking regulators are strongly encouraging).
- Weaknesses: It would not be an economically neutral solution if interest rates normalize. Additionally, it could create substantial operational and secondary market complexity if thousands of loans have different negotiated spread adjustments.
Option Two: Replace LIBOR with SOFR flat (e.g., no spread adjustment) and no margin adjustment.
- Example: LIBOR + 300 bps à SOFR + 300 bps
- Strengths: This is an operationally simple solution that encourages borrowers to transition from LIBOR.
- Weaknesses: There is potentially material value transfer from the lender to the borrower and it could have secondary market implications when hardwired LIBOR-based assets fall back using a higher ARRC spread adjustment.
Option Three: Replace LIBOR with SOFR flat (e.g., no spread adjustment) and with a margin adjustment (which can be spot, negotiated or economically neutral).
- Example: 3M LIBOR + 300 bps à 3M SOFR + 326 bps
- Strengths: Depending on margin changes, it may be more economically neutral than some other alternatives. In addition, it is operationally simpler than having separate spread adjustments on new loans.
- Weaknesses: The adjusted margin may not prove durable, and borrowers’ and lenders’ interpretation of margin increases could differ over time even if the total loan cost is economically neutral.
Option Four: Start the loan with the spot LIBOR-SOFR spread adjustment and use graduated increases (e.g., 1.5 bps per quarter) or flip from spot to ARRC spread adjustment at LIBOR cessation.
- Day 1: LIBOR + 300 à SOFR + spot spread + 300
- June 30, 2023: 3M LIBOR + 300 à 3M SOFR + 26 bps + 300 or3M SOFR + 326
- Strengths: This approach is economically neutral and should align the references rates/spreads on new SOFR loans with billions of dollars of assets falling back from LIBOR to SOFR using the ARRC spread adjustments.
- Weaknesses: If it is not done on a fixed, market-wide calendar, it could be the most complicated solution until LIBOR cessation in June 2023.
Bottom Line: Market participants understand that they must stop originating LIBOR based loans by the end of the 2021. However, the fact that the spot spread differential between LIBOR and SOFR is abnormally low may be creating some hurdles to the adoption of replacement rates. There are solutions – none of which are perfect – and as loan parties negotiate new credit agreements, they should be aware of both the economic and operational implications of any approaches they choose.