LIBOR transition - forward-looking term SOFR is here
Very shortly, the U.S.-based Alternative Reference Rates Committee (ARRC) will make its much-anticipated formal recommendation of forward-looking term Secured Overnight Financing Rates (Term SOFR) administered by the CME Group. This recommendation, together with a series of recommended loan conventions and best practices published by ARRC, mark an important milestone in the transition from USD LIBOR to SOFR.
Term SOFR is an attractive replacement for USD LIBOR because, like LIBOR, Term SOFR allows borrowers and lenders to know the benchmark interest rate on a loan at the beginning (as opposed to near the end) of each interest period by simply looking at the relevant Bloomberg/Reuters page. These features facilitate borrowers’ cashflow and liquidity management and provide operational and systems convenience for all concerned.
ARRC’s formal recommendation of the CME Group’s Term SOFR reference rates and its recent publication of recommended Term SOFR loan conventions and best practices mean that market participants should have what they need to use Term SOFR in syndicated and bilateral loans.
We expect Term SOFR to be a popular choice (particularly among lenders in Asia) because of its notable operational and other advantages over complex and document-intensive backward-looking SOFR calculation methodologies, which do not allow borrowers and lenders to know the benchmark interest rate on a loan until about a week (depending on the length of the lookback period) before interest payment is due at the end of the interest period.
In the U.S. loan market, ARRC’s recommended contractual fallback language already places Term SOFR at the top of the benchmark replacement waterfall. In the international loan market, while the LMA’s/APLMA’s standard documentation (which are based on recommendations made by the UK-based Sterling Working Group as opposed to ARRC) currently do not contain a fallback to Term SOFR, adjustments can be made to any loan document to achieve this outcome.
In this article, we will take a closer look at Term SOFR, how it differs to existing backward-looking SOFR calculation methodologies, and ARRC’s recommended Term SOFR loan conventions and best practices on when to use Term SOFR. In particular, ARRC’s recommended loan conventions provide important guidance for documenting and calculating interest on Term SOFR loans.
1. What is Term SOFR?
SOFR is a benchmark rate administered by the Federal Reserve Bank of New York (New York Fed) which has been selected to replace USD LIBOR. SOFR itself is a backward-looking overnight rate because it is based on overnight transactions in the U.S. Treasury repo market. The backward-looking nature of SOFR means that it is not possible to know tomorrow’s SOFR – it is only possible to know the previous business day’s SOFR.
In contrast, Term SOFR is a forward-looking rate based on transactions in the large and growing SOFR derivatives markets, including SOFR futures and SOFR overnight index swaps (OIS) transactions. In other words, Term SOFR (which is forward-looking) reflects the SOFR derivative market’s expectations as to what will happen to interest rates, while overnight SOFR (which is itself backward-looking) reflects what actually did happen to interest rates overnight. Where there is a deep and liquid SOFR derivatives market, market expectations are generally close to actual movement in interest rates, which is what makes Term SOFR sufficiently reliable to receive ARRC’s endorsement.
In an effort to further enhance the liquidity of SOFR derivatives markets, ARRC recently supported the recommendation made by the U.S. Commodity Futures Trading Commission’s Market Risk Advisory Committee (MRAC) that interdealer brokers change USD linear swap trading conventions from USD LIBOR to SOFR on 26 July 2021.
2. Term SOFR reference rates to be recommended by ARRC
The Term SOFR reference rates to be formally recommended by ARRC include the 1-month, 3-month and 6-month ‘CME Term SOFR Reference Rates’ administered by CME Group Benchmark Administration Limited. Since Term SOFR is based on SOFR derivatives markets data, it is not surprising that ARRC would recommend Term SOFR reference rates administered by the CME Group, which operates the world’s leading SOFR futures market.
Further information about the CME Term SOFR Reference Rates, including their calculation methodology, how to access them and their compliance with the IOSCO Principles for Financial Benchmarks and other benchmark regulations are available on the CME Group’s webpage.
3. Why Term SOFR is an attractive alternative to backward-looking SOFR calculation methodologies
The inherently backward-looking nature of overnight SOFR presents unique LIBOR transition challenges for commercial loan markets which have, for the past 30 years, relied on forward-looking term LIBOR reference rates which are easily obtainable on Bloomberg/Reuters screens and enable the benchmark interest rate on a loan to be known at the beginning of each interest period.
In particular, the following cash management, operational, systems and documentation challenges associated with backward-looking SOFR calculation methodologies are what makes Term SOFR so attractive to lenders and borrowers.
- In the absence of Term SOFR, the interest rate for a SOFR-based loan would generally be determined ‘in arrears’, which means the applicable overnight SOFR (a backward-looking rate) is applied to each day during an interest period. To partly mitigate the payment certainty and liquidity management challenges that the backward-looking nature of overnight SOFR presents to borrowers, a lookback period of 5 business days is commonly applied such that the overnight SOFR from 5 business days ago is used for each day during the interest period. The advantage of having a lookback period is that the interest rate will be known about a week (depending on the length of the lookback period) before interest payment is due at the end of the interest period. While this is not as ideal or convenient as knowing the interest rate at the beginning of the interest period (as is the case for LIBOR and Term SOFR), it is still preferrable to only knowing the actual amount of interest payable at the end of such period when payment is due (as would be the case if no lookback period is applied).
- In addition to the lookback period adjustment, because SOFR is an overnight rate, it is often compounded on a daily basis over the interest period in recognition of the fact that the borrower does not pay interest owed every day and therefore the accumulated interest owed but not yet paid should itself accrue interest. More specifically, a non-cumulative compounding methodology is used so that it is possible to calculate accrued interest on any day during an interest period to facilitate prepayments and secondary loan trading activity. However, the non-cumulative compounding methodology for SOFR is incredibly complex, which presents operational and systems challenges to lenders and borrowers.
- Those who are familiar with the LMA’s/APLMA’s standard risk-free reference rate (RFR) documentation would also be aware that fully documenting the non-cumulative compounding methodology can add around 30 pages of highly complex mathematical formulas and legal provisions to a typical loan agreement.
As discussed below, the abovementioned cashflow management, operational, systems and legal documentation issues generally do not exist for Term SOFR, the loan conventions for which are similar to existing LIBOR loan conventions because they are both forward-looking term rates that appear on a Bloomberg/Reuters screen.
4. ARRC’s recommended loan conventions for Term SOFR
ARRC’s recommended loan conventions provide important guidance for documenting and calculating interest on loans that reference Term SOFR. Since LIBOR and Term SOFR are both forward-looking term rates that appear on a Bloomberg/Reuters screen, most of the loan conventions for Term SOFR and LIBOR are quite similar. Among other things, ARRC’s recommended loan conventions for Term SOFR provide that:
- Available tenors and publication dates: 1-month, 2-month and 3-month CME Term SOFR Reference Rates will be published on each day that the New York Fed calculates and publishes SOFR. A 12-month tenor Term SOFR is also being developed by CME.
- Business day definition: “U.S. Government Securities Business Day” should be defined as any day except for a Saturday, Sunday or a day on which the Securities Industry and Financial Markets Association (SIFMA) recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in U.S. government securities.
- Business day convention: The“Modified Following Business Day”convention should be used, meaning that payments that are scheduled to be paid on a day that falls on a non-business day will be adjusted to the next succeeding business day, unless that business day falls in the next succeeding calendar month, in which case the interest payment date will be the preceding business day.
- Interest rate determination date (“Quotation Day” in LIBOR parlance): The Term SOFR reference rate published two U.S. Government Securities Business Days prior to the first day of an interest period should be used to set the benchmark interest rate for that interest period, similar to existing LIBOR loan conventions.
- Drawdown notices: The borrower should provide a drawdown notice three U.S. Government Securities Business Days prior to the drawdown date, similar to existing LIBOR loan conventions.
- Day count convention: The day count convention should be Actual/360 days, which is the standard convention in U.S. money markets. However, it is possible to use other day count conventions (e.g., Actual/365 days).
- Rounding: Like LIBOR, Term SOFR is published to five decimal places and dollar amounts can be calculated to two decimal places.
- Credit Adjustment Spread (CAS): ARRC has recommended that legacy loans which fall back from LIBOR to SOFR should use a static CAS, being the five-year historical median difference between LIBOR and SOFR, which was fixed and published by Bloomberg on 5 March 2021. Relevantly, the fixed and static CAS for USD 1 month is 11.448 bps, for USD 3 months is 26.161 bps and for USD 6 months is 42.826 bps.
- Interest rate floors: For new loans, any interest rate floor should apply to Term SOFR itself. For existing loans, any interest rate floor should apply to the sum of Term SOFR and the applicable CAS.
- Temporary unavailability of Term SOFR: There should be a temporary fallback if Term SOFR is not available as of 5 pm (New York time) on an interest rate determination date, such as falling back to the applicable Term SOFR that was published on the first preceding U.S. Government Securities Business Day, as long as such day is not more than three U.S. Government Securities Business Days prior to the interest rate determination date. Alternatively, some parties may prefer to use interpolation where Term SOFR for a particular tenor is temporarily unavailable.
- Fallback language: In addition to the above, robust and workable fallback language should be included in loan agreements.
ARRC’s recommended Term SOFR loan conventions are voluntary and may not be applicable to all commercial loans. Each market participant should decide for itself whether and to what extent to use these recommended conventions in its transactions.
5. ARRC’s recommended best practices about when to use Term SOFR
ARRC’s recommended best practices reflect the principle that the use of Term SOFR should be in proportion to the depth of transactions in the underlying derivatives market and should not materially detract from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct the Term SOFR itself. ARRC notes that its recommended best practices are voluntary and that each market participant should make its own independent evaluation and decision about whether or to what extent any recommendation is adopted.
ARRC’s recommended best practices about when to use Term SOFR distinguish between new and legacy transactions and between product types, as summarised in the table immediately below and as discussed in greater detail further below.
Summary table – ARRC’s recommended best practices about when to use Term SOFR
ARRC’s recommended best practices for using Term SOFR in legacy transactions: ARRC notes that its recommended contract fallback provisions for floating rate notes, bilateral and syndicated business loans and securitisation transactions already place Term SOFR at the top of the fallback waterfall. This means that legacy contracts which have adopted ARRC’s fallback language without modification will, if the relevant tenor exists, fall back to the applicable Term SOFR once the contractual LIBOR replacement date occurs. ARRC also notes that under New York’s ‘legislative solution’ to tough legacy LIBOR contracts, LIBOR-based instruments governed by New York law that do not provide effective fallbacks will transition to the applicable SOFR-based rate recommended by ARRC. ARRC states that it expects to make recommendations for the New York legislation that are consistent with its contract fallback provisions.
ARRC’s recommended best practices for using Term SOFR in new transactions: In terms of new transactions, ARRC generally recommends that market participants use backward-looking overnight SOFR, particularly in markets where transition to SOFR has been relatively successful, such as floating rate notes, U.S. consumer loans and securitisations. However, ARRC also acknowledges that the use of backward-looking overnight SOFR has presented particular challenges for loan markets.
Accordingly, ARRC supports the use of Term SOFR in addition to other forms of SOFR for business loans, particularly syndicated facilities, middle market loans and trade finance loans. ARRC also recognises that Term SOFR may also be appropriate for certain securitisations that hold underlying business loans or other assets that reference Term SOFR.
However, ARRC does not support the use of Term SOFR for the vast majority of derivatives markets, because these markets already reference backward-looking SOFR compounded in arrears (e.g., the ISDA 2020 IBOR Fallbacks Protocol) and transitioning derivatives markets to SOFR is essential to ensure there is a sufficiently deep and liquid SOFR derivatives market to support the construction of Term SOFR in the first place. Therefore, ARRC recommends that any use of Term SOFR derivatives be limited to end-user facing derivatives intended to hedge cash products (such as loans and bonds) that reference Term SOFR.
6. Use of Term SOFR in loan documents
Since the CME Term SOFR Reference Rates are screen rates that are available on the relevant Bloomberg/Reuters page, they can be incorporated into a loan agreement (including LMA/APLMA standard documentation) in a similar manner to how legacy loan agreements incorporated LIBOR screen rates. While the legal documentation exercise may not be as complex as fully documenting the non-cumulative compounding methodology, loan documents referencing Term SOFR should be carefully crafted to: (1) reflect appropriate Term SOFR loan conventions; (2) include robust fallback provisions and, if applicable, rate switch mechanisms; and (3) contain future-proof definitions of Term SOFR and other key concepts.