March 24, 2021 - This week, the ARRC publicized its stance on Forward Looking Term SOFR. First, the ARRC announced that it would not be in a position to recommend Term SOFR by mid-2021 and may not be in a position to recommend Term SOFR by the end of 2021. Second, the ARRC announced that it is “still evaluating the limited set of cases in which it believes a term rate could be used”. We discuss these announcements – and their implications for syndicated loans and CLOs – below.
Recommending a Term Rate. The ARRC stated that its “recommendation of an [Term SOFR] administrator was always contingent upon certain conditions being met — including the development of sufficient liquidity in SOFR derivatives markets, and developing recommendations for an appropriately limited scope of use for the term rate. While trading activity in SOFR derivatives is growing, at this time, the ARRC believes that it is not yet in a position to recommend a term rate with confidence based on the current level of liquidity in SOFR derivatives markets.” It added that the US Banking Regulators have said that LIBOR originations must end by the end of 2021 and that the “ARRC cannot guarantee that it will be in a position to recommend an administrator that can produce a robust forward-looking term rate by the end of 2021.” Put together, this suggests that a Term SOFR may not be recommended by the ARRC before LIBOR originations must cease.
Moreover, it is far from clear that the ARRC would recommend the use of Term SOFR for new loan originations. The ARRC further noted that it “is still evaluating the limited set of cases in which it believes a term rate could be used.” And in the recent ARRC SOFR Symposium, speakers pointed to the UK’s Sterling Working Group’s (“SWG”) “Use Cases of Benchmark Rates” as a potential model for the ARRC’s approach. The UK Use Cases stated that “SONIA compounded in arrears was appropriate and is likely operationally achievable for approximately 90% of new loan deals by value and that alternative rates would likely be required for 10% of new loan deals by value”. The SWG identified supply chain finance, receivables financing and export financing and emerging market loans as sectors that would most benefit from a Term SONIA. In contrast, the SWG felt that sophisticated borrowers could use SONIA compounded in arrears.
Impact on Loan & CLO Markets: If the ARRC may not recommend the use of Term SOFR by the end of 2021, and potentially does not include it in the use case for new business loans, what does this mean for the syndicated loan market?
For fallbacks, it’s hopefully a modest risk. USD LIBOR cessation for most tenors has been pushed out to June 30, 2023, and there is a good chance that an ARRC Recommended Term SOFR would exist by then. Nonetheless, lenders should be aware that ARRC Hardwired Fallback Language for loans has a “waterfall” of replacement rates upon LIBOR cessation. The first step in the waterfall is Term SOFR, which is defined as “…the forward-looking term rate based on SOFR that has been selected or recommended by the Relevant Governmental Body (emphasis added).” The Relevant Governmental Body is the Federal Reserve, the FRBNY or a committee officially endorsed or convened by the Fed or FRBNY. Thus, if Term SOFR exists but is not selected or recommended by the ARRC, the Fed or a similar body, it may not be used in the Hardwired Fallback.
In a similar vein, for new loans, there is the concept of a “flip forward” to Term SOFR in the LSTA Daily SOFR Concept Credit Agreements. In effect, if a new loan is originated on Daily Simple SOFR or Daily Compounded SOFR and the Relevant Governmental Body subsequently recommends Term SOFR, the reference rate can transition from Daily SOFR to Term SOFR. Market participants should be mindful that both the definition of “Term SOFR” and “Term SOFR Transition Event” are linked to there being a forward looking term rate that is selected or recommended by the ARRC.
Bottom line: For a number of months, the ARRC has signaled that it is uncomfortable with the broad adoption of Term SOFR in cash markets. In the past week, it formalized this position by pushing out the date by which it may recommend Term SOFR and announcing that there may be limited use cases for Term SOFR. Ultimately, loan and CLO market participants might view this as a warning shot and may wish to think deeply about the rates they would use long term if an ARRC-Recommended Term SOFR is not a viable option.
*Note that the US loans are more likely to be funded and traded and thus may be more likely to look to a Simple Daily SOFR if an “in arrears” rate were used.