January 11, 2022 - We did it. Like Y2K, we made it through a potentially disastrous event without material disruption. And, like Y2K, this was largely due to an invisible army toiling to make LIBOR transition smooth(ish).
Having made it to 2022, what’s on deck now this year? The LSTA tackled that issue at BofA’s CLO Conference. We flagged two key themes to consider: First, understanding the economics of SOFR world. Second, what people must do to really be prepared for a (nearly) all-SOFR, all-the-time world.
Starting with the economics, one of the questions we frequently received is “If SOFR is a risk-free rate, does that mean loans are no longer floating rate?” Slide 3 of the presentation answers that in the negative. While SOFR is risk free, it is very much influenced by Fed rate policy (just like LIBOR). When rates are rising, both LIBOR and SOFR generally rise; when rates are falling, both LIBOR and SOFR generally fall. However, because SOFR is a risk-free rate, it tends to be lower than LIBOR. As Slide 3 demonstrates, over the past 20 years, LIBOR and SOFR have been within 5-30 bps 70% of the time.
However, SOFR is lower than LIBOR and, importantly, the SOFR Term Curve (e.g., the relationship between 1- and 3-month SOFR) tends to be flatter than LIBOR. This is demonstrated on Slide 4 – and is the rationale for the Credit Spread Adjustment (“CSA”) Curve. SOFR is represented by the green line and LIBOR by the gold line. What should be clear is that SOFR is flatter. For this reason, we have seen a quasi-typical CSA Curve emerge of 10 bps for 1M SOFR, 15 bps for 3M SOFR and 25 bps for 6M SOFR. The red line in Slide 4 reflects the “SOFR+CSA” curve. By using a CSA curve, the reference rate is higher (closer to LIBOR) and more steeply sloped (like LIBOR). Of course, a CSA curve is not the only means of bringing SOFR economics closer to LIBOR. One can have a flat CSA, a spread adjustment that is embedded in the margin itself or even a spread adjustment that is embedded in “Adjusted SOFR”. The LSTA’s Term SOFR Concept Credit Agreement demonstrates different approaches to SOFR and the CSA, and the LSTA’s LIBOR Transition Checklist provides links to real world examples of these approaches. There are strengths and weaknesses of each approach and lenders are advised to know what is in their documentation.
Another economic issue involves the floor, which may ease the transition process – as long as transition occurs while the floor is in effect. Slide 5 compares the weighted average interest rate floor in the S&P LSTA Leveraged Loan Index (about 40 bps) to today’s 3M LIBOR (about 24 bps) and 3M SOFR+CSA (about 26.5 bps). If the floor is above LIBOR and SOFR and if the floor ports over at transition, then it may ease both the economic and operational worries. But if we’ve broken through the floor – check those interest rate futures! – or the floor doesn’t port over, it may not be as helpful.
Now that we know the economics, where does transition stand in early 2022? At a pretty good spot (Slide 6). Commentators have been analogizing LIBOR transition to Y2K – a lot of talk but ultimately not terribly disruptive. We’d take that analogy further: Like Y2K, 12.31.21 wasn’t disruptive because of all the people working behind the scenes for years. But here we are in 2022, with a few LIBOR loans being done. Why? First, regulators have said that LIBOR loans underwritten in 2021 can be syndicated in 2022. Second, it is the banking regulators that are forbidding new LIBOR loans. Entities regulated by the SEC – like private credit or non-bank originators –still theoretically can originate new LIBOR loans. And accordions that are uncommitted but contemplated by pre-existing contracts are a bit of a gray area. Still, we expect this residual activity to diminish relatively quickly. As the residual LIBOR syndications ebb, lenders must be ready for a SOFR world. This includes getting a CME Term SOFR license, and ensuring that systems can handle all SOFRs (as well as CSRs) and the various permutations of CSAs. But we’re still not done once we get all the SOFR origination wrinkles ironed out. At that point, we will turn to remediation: There are something like $5 trillion of legacy LIBOR loans that need to transition over and most – hopefully! – won’t all transition at LIBOR cessation in June 2023. This means lenders must have a remediation plan in place, a plan to track “Early Opt-In” Amendments and a strategy for voting on each amendment that comes through. But, like Y2K, the hard preparatory work has happened. Now we just block and tackle.