Average spreads can be a fair measure, but for savvy borrowers, paying attention to the daily spread can be worthwhile.
As we approach the three-month mark of the formal end of LIBOR loan originations, it’s worth taking a look at how interest rates have changed over time and how that affects the adoption of new replacement rates. For new loans, loans that are maturing and loans that are being increased or subject to major modifications, there is no choice but to transition to a new rate. However, for legacy loans that have a maturity date past the June 30, 2023, complete end of LIBOR and that otherwise do not need modification, there is flexibility on when such transition must occur.
LIBOR and SOFR are independent rates. Although they roughly track each other, the difference or “spread” between the two rates on any given day varies. In determining a market approach to quantifying this spread for purposes of coming up with a fair adjustment that doesn’t cause the rate to change significantly during transition, the International Swaps & Derivatives Association (ISDA) and the Alternative Reference Rates Committee of the New York Federal Reserve Bank (ARRC) decided to measure the median of this spread over the five-year period preceding the formal March 5, 2021, announcement of the LIBOR end date. These spread adjustments for U.S. dollar LIBOR are 0.11448 percent for a one-month interest period, 0.26161 percent for a three-month interest period and 0.42826 percent for a six-month interest period. The adjustments reflect that, on average, one-, three- and six-month LIBOR was higher than one-, three- and six-month SOFR by 0.11448 percent, 0.26161 percent and 0.42826 percent, respectively, during that specific five-year period.
Average spreads can be a fair measure, but for savvy borrowers, paying attention to the daily spread can be worthwhile. Up until recently, interest rates have been historically low. In September 2021, one-month SOFR was only about 0.03 percent lower than one-month LIBOR, three-month SOFR was only about 0.08 percent lower than three-month LIBOR, and six-month SOFR about 0.10 percent lower than six-month LIBOR. Switching to SOFR in September 2021 and adding the standard ARRC spread adjustment would have resulted in a borrower paying a higher interest rate at that time (by about 0.08448 percent, 0.18161 percent and 0.32826 percent, respectively). The spreads ticked up slightly in December 2021—to about 0.04 percent, 0.12 percent and 0.14 percent―but still well below the ISDA/ARRC spread adjustments.
Fast forward to the Russian invasion of Ukraine in late February and the Fed’s 0.25 percent rate increase on March 16, 2022, to combat inflation. Now, the spreads are quite different. As of March 25, 2022, one-, three- and six-month Term SOFR were 0.30404 percent, 0.62403 percent and 1.0126 percent, respectively, and one-, three- and six-month LIBOR were 0.44514 percent, 0.98296 percent and 1.45114 percent, respectively. This results in spot spreads for that day of 0.1411 percent, 0.35893 percent and 0.43854 percent, respectively, all higher than the ISDA/ARRC spread adjustments. The rates for the other days since the Fed rate increase fluctuated, but were generally in that same range.
What happened? Credit sensitivity. For all its shortcomings, LIBOR is an unsecured lending rate that is sensitive to changes in credit risks in the market. SOFR is based on secured overnight borrowings in the repo market for U.S. government Treasury securities, among the most liquid and creditworthy collateral. When risks, perceived or actual, increase in the market, LIBOR is more sensitive to those risks and may increase in reaction to it. The repo market can also react to increased risks, but the financial substance of those transactions is more insulated from outside influences due to their short-term nature and solid collateral. These are some of the qualities that caused the ARRC to select SOFR as the recommended replacement rate. CME Group uses a proprietary calculation methodology to generate the forward-looking Term SOFR rates, but the rates are still based on secured Treasury repo transactions.
It is worth noting that the backward-looking 30-, 90- and 180-day SOFR averages published by the New York Fed have been slower to react. Although the 30-day SOFR average moved up about six basis points in the week after the Fed rate increase, the 90-day and 180-averages barely moved, weighed down by the prior 83 and 173 days of lower rates during less risky times.
With the war in Ukraine expected to continue, and inflation to continue to increase unless the Fed raises rates again, it is fair to conclude that interest rates may rise in the near term. In all likelihood, a credit-sensitive rate like LIBOR is likely to rise higher and faster than a secured rate like SOFR would.
This has interesting implications for new and legacy loans. Prior to recent events, pricing SOFR loans at the ISDA/ARRC spread adjustment was a tough sell for lenders. Savvy borrowers and those with bargaining leverage have been delaying the switch or negotiating lower spread adjustments. Newly originated SOFR loans were never subject to the ISDA/ARRC spread adjustment conventions. It’s fairly common for one-month, and sometimes one- and three-month, SOFR loans to be priced with a 10 basis point adjustment rather than strict 11.4488 and 26.161 basis point spreads. A common practice that has developed in the market is to price one-, three-and six-month SOFR loans with 10/15/25 basis point adjustments, respectively.
Legacy loans are not that much different. In its June 30, 2020, announcement regarding spread adjustments, the ARRC recommended using the ISDA spread adjustments. The announcement clearly states that “[t]he ARRC’s recommended methodology is for market participants’ voluntary use… .” Subject to market constraints, freely negotiating lenders and borrowers can select whatever spread adjustment they want for legacy loans. So far, this has tended to mirror the lower spread adjustments found in newly originated loans, or borrowers holding off on transition and the effect of an immediate interest rate increase.
Lenders may be hard-pressed to justify raising spread adjustments over the ISDA/ARRC spreads, even if the spot spreads are significantly higher. In theory, the five-year median spread calculation performed by ISDA/ARRC should account for these ups and downs in rates. However, the ISDA/ARRC lookback period did not include a continuing pandemic with worsening global supply chain issues and a war that sent the price of gasoline over $5 per gallon. Lenders tend to adjust their loan pricing on much shorter time frames than five years and may eventually seek to do so here.
With spot spreads higher than the ISDA/ARRC spread and interest rates generally expected to rise in the near future, now may be the time for borrowers to consider the switch from “credit sensitive rates that could move up like LIBOR has done in times of economic stress” to a more stable SOFR rate. Lenders that have been contemplating the transition of their legacy loans may find borrowers more willing to do so, but lenders may decide to hold on to the benefit of their higher LIBOR bargain as long as they can.
About Duane Morris
Duane Morris attorneys assist lenders in formulating their documentation and strategy for post-LIBOR loans and applying amendments that address the interest rate changes in legacy loans through general, descriptive measures. As the end of LIBOR draws closer, Duane Morris’ LIBOR Transition Team will continue to monitor developments and issue additional Alerts. Stay tuned to the LIBOR Transition Team webpage and blog for updates.
For More Information
If you have any questions about this Alert, please contact Roger S. Chari, Joel N. Ephross, Amelia (Amy) H. Huskins, Phuong (Michelle) Ngo, Natalie A. Stewart, any of the attorneys in our Banking and Finance Industry Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.