On 29 July 2021, the US Alternative Reference Rates Committee (ARRC) announced that it formally recommended the forward Term SOFR published by CME Group, Inc. (CME) for use in connection with business loans.
This announcement is significant for syndicated loans denominated in US Dollars for two principal reasons. First, the ARCC’s recommendation of a Term SOFR is the first step in the waterfall in the ARRC’s recommended LIBOR fallback language for loans and for many other financial products.1 Consequently, when a trigger event occurs, Term SOFR would become the LIBOR replacement in many loan agreements.
Second, Term SOFR likely will be extensively used in USD loan agreements going forward, since interest rate alternatives to USD LIBOR that are backward-looking have seen tepid acceptance. Term SOFR may also be seen as a competitor of certain forward-looking credit-sensitive rates (CSRs) that are available.2
The ARRC announcement followed a key step in the ARRC’s “SOFR First” initiative, which was designed to increase liquidity in the SOFR swaps markets. As one of the principal steps of that initiative, on 26 July 2021, interdealer brokers began to replace trading of LIBOR linear swaps with the trading of SOFR linear swaps. The ARRC had said that if liquidity in SOFR swaps increased as they anticipated following this step, the ARRC would recommend Term SOFR for loans very soon thereafter. In fact, the ARRC recommendation occurred just three days later, on 29 July.
The ARRC’s recommendation of Term SOFR completed the steps of its Paced Transition Plan. Since that plan was first adopted in 2017, it has listed approval of Term SOFR as its last step, specifying that such step would occur before the end of 2021, if sufficient liquidity in SOFR existed in the market to support such recommendation.
Term SOFR is based on overnight SOFR, which is a risk-free rate (RFR), and does not reflect a premium for counterparty credit risk. Other versions of SOFR that have been suggested for loan agreements involve compounding in arrears (either compounding the rate or compounding the balance) or the daily calculation of interest in arrears, without compounding (e.g., Daily Simple SOFR). In contrast, Term SOFR is known in advance, at the time of borrowing, like LIBOR is now. Compounded SOFR in arrears and Daily Simple SOFR may still be used by borrowers and lenders if they choose.
Using a forward term rate for USD loans will result in a different market convention than in effect for Sterling loans, where the market convention is to use SONIA compounded in arrears.3
The ARRC recommendation allows loan agreements to use Term SOFR in place of LIBOR going forward, either as a replacement for LIBOR (whether pursuant to the operation of a fallback provision or otherwise) or in new deals. The ARRC has proposed loan conventions and use cases for Term SOFR. Notably, under the use cases, Term SOFR is not generally recommended for use in derivatives, with limited exceptions (including a hedge of a SOFR loan or other cash product). The limited use cases for Term SOFR reflect a concern that trading in Term SOFR may detract from liquidity in overnight SOFR, which would render that rate less robust.
Because Term SOFR and LIBOR are so conceptually similar, the ARCC believes that many loan agreement forms will not require extensive revision to substitute Term SOFR for LIBOR.4
However, the US bank regulators have stated that they will view the origination of new USD LIBOR deals after the end of 2021 as a safety and soundness risk. Despite this development, USD LIBOR for most tenors will continue to be quoted through 30 June 2023; LIBOR quotes for most other currency-tenor pairings will cease on 3 January 2022.
Certain CSRs have been used in the loan market instead of LIBOR, including Ameribor and BSBY.5 Term SOFR is not a CSR, and differs from LIBOR in that respect. While some lenders and borrowers may prefer a CSR to SOFR or Term SOFR going forward, many expect Term SOFR to be significantly used.
As noted above, Term SOFR is an RFR, since it is based on overnight SOFR. Lenders will likely add a credit spread adjustment to Term SOFR or reflect such an adjustment in the margin (which would therefore, all things be equal, be expected to be higher than the margin quoted for a LIBOR loan).
Please visit Baker McKenzie’s LIBOR Transition Hub for further information concerning the LIBOR transition.
2 See our client alert Are Overnight Rates Overrated?
3 Although versions of term SONIA exist, UK regulators have put in place a limited use case of term SONIA in the UK loan market. See, e.g., The Working Group on Sterling Risk-Free Reference Rates, Use Cases of Benchmark Rates: Compounded in Arrears, Term Rate and Further Alternatives (January 2020); see also FICC Market Standards Board, Standard on use of Term SONIA reference rates.
4 See LSTA, Term SOFR Conventions: (Almost) Just Like LIBOR.
5 BSBY was severely criticized by Gary Gensler, the SEC chair. See Gensler, Prepared Remarks Before the Financial Stability Oversight Council, June 11, 2021. Bloomberg, which publishes BSBY, has published a paper in response: Bloomberg Short-Term Bank Yield Index BSBY report: Additional analysis and key facts.