July 21, 2021 - by Meredith Coffey. This morning, the ARRC released best practice recommendations for the use of a SOFR Term Rate.
Bottom line: As expected, business loans – including syndicated loans – are in scope for the use of Term SOFR. As hoped, certain SOFR Term Rate derivatives are permitted, but only in the context of an end-user facing derivative intended to hedge a Term SOFR cash product. And, rather delightfully, the ARRC added that Term SOFR may also be appropriate for securitizations (e.g., CLOs) holding Term SOFR loans. We discuss in detail below.
Background: The ARRC has long recommended SOFR as the replacement rate for USD LIBOR, and much of the focus has been on “overnight” rates such as Daily Simple SOFR or Daily Compounded SOFR. However, the ARRC recognized the need for Term SOFR as well for some products – like business loans – that have had trouble adapting to an overnight rate. Earlier this year, the ARRC stated it would set out a scope of use for Term SOFR and formally recommend it, based on a series of principles. In the summer, the ARRC announced that it would recommend CME Term SOFR when it formally recommended SOFR. Today, the ARRC also released Recommended Conventions for use of Term SOFR in Business Loans to facilitate its use. Now, all that is left is for the ARRC to formally recommend Term SOFR, which is expected to occur shortly after the SOFR First initiative is executed on July 26th.
Implications for LIBOR Fallbacks: Once Term SOFR is formally recommended, the first step in LIBOR Hardwired Fallbacks – generally the fallback to Term SOFR plus the ARRC spread adjustment – will be available and all parties will know the rate to which their (hardwired) LIBOR contracts fall back. This is very good news for loans and CLOs because Term SOFR is much more implementable than the Daily SOFR alternatives. Additionally, the fact that CLO liabilities and loan assets should fall back to the same rate mitigates basis risk. Of course, fallback language is most relevant in mid-2023 when USD LIBOR ceases for legacy contracts. (As a reminder, LIBOR is not to be used in new contracts after the end of 2021.)
Implications for new loans and CLOs: The ARRC was less fulsome in its scope of use for new contracts. There it suggested that most products can adopt – indeed, have adopted – daily SOFR and SOFR Averages (in advance); these include FRNs, ARMs, Student Loans and most securitizations. However, these SOFR rates have been more challenging for business loans (and the securitizations that hold them). Thus, the ARRC noted that it “supports the use of SOFR Term Rate in addition to other forms of SOFR for business loan activity —particularly multi-lender facilities, middle market loans, and trade finance loans—where transitioning from LIBOR to an overnight rate has been difficult and where use of a term rate could be helpful in addressing such difficulties. The ARRC also recognizes that the SOFR Term Rate may also be appropriate for certain securitizations that hold underlying business loans or other assets that reference the SOFR Term Rate and where those assets cannot easily reference other forms of SOFR.”
Implications for hedging: While hedging may be less of a focus in the leveraged loan space, it is a material concern in other lending arenas. Indeed, the issue of Term SOFR loans that must be hedged using an overnight SOFR rate had become an increasingly fraught one. (The ARRC was concerned that if the entire derivatives market moved to Term SOFR – which is built on SOFR Futures trading – then Daily SOFR liquidity could be hollowed out. The hedging counterparties were concerned with a perfect hedge, hedging costs and operational complexity.) Thus, the ARRC did not recommend and does not support the use of Term SOFR for the vast majority of the derivatives market. However, the ARRC recognized, for instance, that a borrower may wish to hedge their business loan, so instead recommended “that any use of SOFR Term Rate derivatives be limited to end-user facing derivatives intended to hedge cash products that reference the SOFR Term Rate.”
Bottom Line: This is all very good news for loan (and CLO) parties that wanted to use Term SOFR (and potentially even hedge their positions). We hope that with this important step, market participants now feel fully equipped to adopt replacement rates in the near term – as they must do.