February 3, 2022 - We are one month into SOFR World and the transition has been as boring as we could have hoped for! Some $80 billion USD leveraged loans and $8 billion of CLOs have emerged in 2022, with the vast majority referencing CME Term SOFR. But how much do people actually know about CME Term SOFR? Details like how it’s constructed, how robust it is, its governance mechanisms – and indeed what happens if it were not published – are often beyond the day-to-day focus of lenders. For this reason, on February 3rd, the LSTA hosted CME experts to really get under the hood of CME Term SOFR, and help our members understand the rate inside and out. We recap the webcast below and members can replay it here.
First off, why Term SOFR? In fact, the Alternative Reference Rates Committee (“ARRC”), the ARRC’s Business Loans Working Group (“BLWG”), the LSTA and its members spent years trying to develop a replacement rate that would work for business loans and CLOs. As slides 3 and 4 show, it is hard to find a clean alternative for LIBOR that met all the needs of the lender community.
The first types of potential replacement rates were the “Daily SOFR” rates – Daily Compounded SOFR and Daily Simple SOFR (Slide 3). Critically, these rates are not known in advance of the interest period, but rather are calculated during the interest period. Thus, the interest rate is unknown until shortly before interest is due. This was unattractive in the loan space, and nearly untenable in the CLO space, where tests such as Interest Coverage (IC) Test must be done prior to interest payments being made. Thus, the loan and CLO markets did not want a Daily SOFR Rate as the primary replacement for LIBOR.
Instead, there was considerable interest in “Known in Advance” Rates where the interest rate was, well, known in advance of the interest period – just like LIBOR (Slide 4). The first possibility was “SOFR Compounded in Advance”, which means that the rate for the previous interest period would be used for the current interest period. For example, if there is a three-month interest period beginning April 1st, the Compounded SOFR Rate for Jan 1st -March 31st would be locked and used. While this rate is known in advance of the interest period and, indeed, is being used for Agency RMBS, it was roundly rejected by business loan lenders. The BLWG surveyed its 500 members, and banks strongly pushed back, noting that borrowers could pick longer – and thus lower – rates when interest rates were rising, exacerbating asset-liability management problems.
Forward Looking Term SOFR also is known in advance of the interest period; CME Term SOFR is constructed from the expected path of rates as indicated by SOFR futures prices. One question that emerged is whether there is sufficient SOFR futures volume to construct a robust and durable rate. As the COW shows, SOFR futures volumes and Open Interest had been climbing through 2021 and shot up in January, after LIBOR was no longer permissible for new contracts. The ARRC recommended CME Term SOFR in July 2021; importantly, the ARRC’s recommended use cases focused on business loans and their securitizations (e.g., CLOs).
The final “Known in Advance” Rates are Credit Sensitive Rates (“CSRs”) that have Term Curves, including BSBY and the Term Ameribors. Banks demonstrated appetite for these CSRs for two reasons. First, they are credit sensitive so they tend to be higher than SOFR and behave more like LIBOR. Second, when it appeared that the ARRC might not recommend a Term SOFR rate before the end of 2021, some banks turned to these CSRs at least in part because they were known in advance of the interest period. However, two events shifted a number of banks’ focus back to SOFR: First, the ARRC ultimately recommended CME Term SOFR last July. Second, the banking regulators discouraged the use of CSRs for any products outside of traditional bank loans.
Ultimately, when the loan and CLO markets worked through the LIBOR replacement options, it became clear that there was limited appetite for Daily Simple SOFR and Daily Compounded SOFR. In the “Known in Advance” rate category, banks were resistant to SOFR Compounded in Advance and regulators pushed back on Credit Sensitive Rates for capital markets products. This largely left Forward Looking Term SOFR as a “Known in Advance” rate that was most acceptable to the largest number of parties.
With that as context, we turned to a detailed presentation of the methodology and governance of CME Term SOFR. This discussion works best with the numerous slides and examples in the presentation. As it is too detailed and quantitative to cover here, we encourage interested parties to watch the presentation and review the slides, and study the CME Term SOFR methodology and FAQs.
While CME Term SOFR was built to be robust in all market environments and has multiple fail safes to ensure a Term SOFR rate will be published, the last four years have taught us that it is critical to have fallbacks in case reference rates cease. Thus, we wrapped the presentation – though not the 34 audience questions! – with a discussion of SOFR fallback language in loans and CLOs (slide 34). Term SOFR leveraged loans are primarily using hardwired fallback language that first falls back to Daily Simple SOFR; if Daily Simple SOFR is not available, the waterfall moves to a streamlined amendment approach. Meanwhile Term SOFR CLO fallback language exists but is evolving. One approach being seen is that if Term SOFR is no longer used or reported, the CLO manager selects the fallback rate being used in the largest percentage of its underlying loans or in notes issued in CLOs priced in the preceding three months. As language continues to develop, members are encouraged to remember that references to rates or adjustments recommended, selected or otherwise acknowledged by the LSTA that may be present in LIBOR fallback language should be avoided.