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This article discusses credit spread adjustments related to the differential in rates between the London Interbank Offered Rate (LIBOR) and the Secured Overnight Financing Rate (SOFR).
While LIBOR and SOFR historically trend together, LIBOR is generally higher than SOFR. Due to the difference in these rates, the Alternative Reference Rates Committee (ARRC) has recommended that a credit spread adjustment be added to SOFR to compensate for the difference between the two rates. This article includes links to related practical guidance.
As LIBOR (also referred to as the Eurodollar Rate) began to be discontinued at the end of 2021, the ARRC established by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York recommended SOFR term rates (Term SOFR) as a replacement for LIBOR. Since LIBOR rates have tended to be higher than SOFR rates, the ARRC recommended a spread adjustment based on the five-year historical median difference between LIBOR and SOFR. The problem is, with current interest rates near zero in the wake of the COVID-19 pandemic, the current actual or spot spread is much lower than the ARRC’s recommended historical spread calculation. This has created a dilemma as to determining the credit spread adjustment for Term SOFR in a manner that is fair to both lenders and borrowers. A number of methods are being considered besides the ARRC-recommended spread adjustment, each with its own economic and operational pros and cons.
For credit agreements that include the ARRC-hardwired fallback language, when replacement occurs, generally LIBOR will be replaced with Term SOFR plus the ARRC historically based spread adjustment. However, for credit agreements that include an amendment approach to LIBOR replacement, do not include LIBOR succession provisions, or are for newly originated loans based on SOFR, the SOFR spread adjustment is now a point of negotiation. The spread determination may be a holdup for lenders to shift from originating new loans using LIBOR to using SOFR. The ARRC spread adjustment may be fair based on historical LIBOR-SOFR spreads and may become fair in the future if the market normalizes.
Currently, however, the ARRC’s spread is significantly more than the spot spread between LIBOR and SOFR. Therefore, some borrowers are hesitant to enter into new loans based on SOFR and pay more in the present, hoping the spread will become fair down the road. The Loan Syndications and Trading Association (LSTA) and other market experts have analyzed a number of alternative approaches to determining the SOFR spread adjustment with considerations as to the impact on lenders on the one hand and borrowers on the other. With certain tenors of LIBOR ending at year-end 2021, followed by all tenors by June 30, 2023, the market needs to shift away from originating or continuing LIBOR loans, and determining the SOFR spread adjustment seems to be standing in the way of this shift.
With LIBOR cessation beginning at the end of 2021, lenders and borrowers have incorporated alternative benchmark interest rate provisions into existing credit agreements and have begun to use alternative interest rates for new loans. SOFR has emerged as the front-runner interest rate for the replacement of LIBOR. To make it more conducive to replacing LIBOR, Term SOFR became available in July 2021 for one-, three-, and six-month tenors to parallel some LIBOR tenors. While LIBOR is a rate that is based on bank credit risk submitted by a panel of banks, SOFR is a risk-free rate based on banks’ cost of borrowing. Accordingly, LIBOR is generally higher than SOFR. Due to this difference, a credit spread adjustment is needed to make SOFR-based loans more economically equivalent to LIBOR-based loans.
The ARRC obtained and studied input from various sources as to the methodologies for determining the spread adjustment. The ARRC settled on using the five-year historical median difference between LIBOR and SOFR, set on March 5, 2021, which includes the following recommended spreads:
While LIBOR and SOFR have historically trended together, in times of market disruption, the difference between the two rates may widen or narrow. For example, during the 2008 financial crisis, the gap was as wide as 100 basis points. With current interest rates historically low, the spot spread for three-month LIBOR and Term SOFR is only approximately seven basis points. For new loans or amendments, borrowers may object to the ARRC-recommended spread given that it currently is considerably higher than the spot spread. While market experts predict that the spot spread will trend closer to the ARRC-recommended spread over time, this may not satisfy today’s borrowers.
Different approaches to pricing SOFR loans have emerged, including various methods of determining a credit spread adjustment or avoiding the spread and including any adjustment into the interest rate margin. The methodologies each have varying economic impact on lenders or borrowers and may or may not be operationally feasible for the parties to administer. The LSTA has published information and commentary on some of these approaches.1 The ARRC also has published details regarding its recommendations.2 The following is a brief summary of the main credit spread adjustment approaches under consideration.
ARRC-Recommended Spread Based on Five-Year Historical MedianThe ARRC recommendation uses spreads for respective tenors based on the five-year historical median difference between LIBOR and SOFR set on March 5, 2021, by the ARRC:
Static Spot Spread at Point in TimeA spot spread is locked in based on the LIBOR-SOFR spread or a negotiated spot spread amount set at the current point in time (separate from the interest rate margin):
No Spread AdjustmentLenders may replace LIBOR with SOFR without any spread adjustment. The lenders and borrower may or may not negotiate an adjustment to the interest rate margin:
Gradually Transition or Flip from Spot Spread to ARRC-Recommended SpreadThe parties may begin with the spot spread and incorporate a transition to the ARRC-recommended five-year median spread, with the transition either gradually over time (i.e., one year) or flipping at complete LIBOR cessation in June 2023:
Dynamic SpreadA dynamic spread changes with the real-time spread between LIBOR and SOFR:
Counsel should ensure that the documentation contains fallback rate provisions prior to discontinuation of LIBOR. Most credit agreements should already have provisions using either the hardwired approach or amendment approach to LIBOR succession with an alternate benchmark rate. If the documentation uses the ARRC-recommended spread adjustment to SOFR, the borrower may consider negotiating to delay when such rate will come into effect until June of 2023—when the ARRC-recommended spread is predicted to more closely track the difference between LIBOR and SOFR.
For existing loans providing an amendment approach to LIBOR succession having Term SOFR replacing LIBOR, or for newly originated loans based on Term SOFR, the issue of the credit spread adjustment for SOFR may be up for negotiation. The parties may be contemplating the approaches discussed in this article.In addition, counsel should consider whether the ARRC-recommended spread adjustment or an alternate method for determining the spread adjustment is appropriate for the transaction, whether it will result in an economically equivalent rate, and whether it is operationally feasible to administer the parties’ preferred method. Certain large lenders may have additional concerns regarding the impact its approach has on the overall market or other aspects of its business.
Finally, counsel should monitor the market and determinations of interest rates and spread adjustments, particularly over year-end 2021.
With the push to transition away from LIBOR and to stop originating new loans using LIBOR as of year-end 2021, lenders and borrowers need to resolve how they will determine the SOFR spread adjustment—assuming SOFR remains the front-runner rate for replacing LIBOR. Perhaps the market will overwhelmingly decide to use one methodology or use the ARRC-recommended spread more or less by default. Or, perhaps, multiple methodologies will be used throughout the market in the near future during the transition, which may create other issues due to a lack of market convention. The market may change or normalize prior to the final cessation of LIBOR in June 2023, which could render the spread determination less of an issue. In any event, practitioners should continue to monitor the approach to determining the SOFR spread adjustment to best advise their lender and borrower clients.
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For an overview of the issues related to replacing LIBOR as the benchmark interest rate in loan documents, see
> LIBOR REPLACEMENT RESOURCE KIT
For a description of how to draft or amend a credit agreement to replace LIBOR as the baseline reference interest rate, see
> LIBOR TRANSITION TO SOFR IN CREDIT AGREEMENTS
For assistance in responding to a client’s inquiry about the cessation of LIBOR, see
> THE CLIENT ASKS: WHAT HAPPENS WHEN LIBOR ENDS?
For a discussion of provisions in credit agreements that allow for a transition to a replacement reference interest rate upon the cessation of LIBOR, see
> MARKET TRENDS 2020/21: LIBOR SUCCESSION CLAUSES
For sample LIBOR replacement clauses, see
> LIBOR REPLACEMENT CLAUSE (HARDWIRED), LIBOR REPLACEMENT CLAUSE (BILATERAL, HARDWIRED), and LIBOR REPLACEMENT CLAUSE (AMENDMENT)
1. See these LSTA publications and presentations: SOFR Spread Solutions: The Price of Imperfection; In Search of “Fair” Spread Adjustments for New SOFR Loans; and LIBOR-SOFR Spread Adjustments: Historical vs Current Levels Podcast. 2. See of the ARRC’s Fallback Recommendations, October 6, 2021.