May 4, 2021 - by Meredith Coffey. While LIBOR transition has been happening in earnest for loans since late 2017, the story has taken a few twists lately with the introduction of Credit Sensitive Rates (CSRs). In a PLI presentation on Tuesday, May 5th, LSTA EVP Meredith Coffey discussed the potential replacement rates, their strengths, their weaknesses and their economics.
In particular, the slides (available here) lay out a grid (Slide 6) contrasting the potential replacement rates and a chart (Slide 7) comparing their economics. Forward Looking Term SOFR, SOFR Compounded in Advance and Credit Sensitive Rates are all known “in advance” of the interest period and therefore would not be disruptive to today’s loan documentation, operations/systems and trading norms. In addition, borrowers would have cash flow certainty. However, the economics of CSRs and SOFRs differ. Credit Sensitive Rates are economically very similar to LIBOR, so there is no need for a spread adjustment on loans that “fall back” from LIBOR to CSRs, and new CSR-based loans likely could use the current LIBOR margin. Because SOFR is a nearly risk-free rate, it should be lower than LIBOR (Slide 7) and therefore a spread adjustment would be necessary on loans falling back from LIBOR to SOFR and a margin adjustment would be needed on new SOFR loans to keep the economics consistent. Additionally, as Slide 7 demonstrates, all the SOFR rates are nearly the same economically. Forward Looking Term SOFR is simply the SOFR Futures market’s best guess of where SOFR Compounded in Arrears will be at a future date. Daily Simple SOFR is economically nearly identical to Daily Compounded SOFR because an interest rate for one day (e.g., published SOFR divided by 360) is so low, compounding it doesn’t increase the overall rate very much. (Try this at home; it’s enlightening!) SOFR Compounded in Advance and SOFR Compounded in Arrears are the same rates; Compounded in Advance simply looks back to the previous period’s interest rate, while Compounded in Arrears uses the current period’s interest rate.
Long story short, the replacement rates in the loan market are still under discussion. Fortunately, we understand the rates and their components – and generally understand their behavior. In turn, loan market participants – once thoroughly schooled in these rates! – should be able to make educated decisions on what is “fit for purpose”. The LSTA, meanwhile, has dedicated considerable humanpower to ensuring whatever rate “wins” will be able to be executed in loan conventions, documentation and systems. Members can join us on our Monday LIBOR Q&A calls to stay abreast of current developments.