The LIBOR Sunset Series: Notes on the US LIBOR transition
The London interbank offered rate (“LIBOR”) for US Dollars, which forms the basis of the majority of US Dollar floating interest rate financial instruments, will commence being phased out at the end of 2021 and replaced with the Secured Overnight Financing Rate (“SOFR”). In the LIBOR Sunset Series, Freshfields’ finance experts answer frequently asked questions about the transition.
Sunset Special: ARRC shuts down Term SOFR in 2021
Ever since the Alternative Reference Rate Committee (“ARRC”) prioritized a Term SOFR rate in its fallback provisions, the US loan market has been (to put it mildly) eagerly anticipating further details for its roll-out. ARRC included Term SOFR in response to feedback from market participants with a preference for a risk free rate (“RFR”) linked term rate, which could replace the existing LIBOR rate, for an easier transition. Despite this, ARRC announced in a symposium on Monday and a formal statement on Tuesday that ARRC did not expect to be able to recommend the use of Term SOFR during 2021 and recommended that market participants should not wait for its publication to transition away from LIBOR.
Why the reluctance to recommend Term SOFR?
ARRC has always taken the position that any Term SOFR requires sufficient volume in the SOFR futures market at various tenors to ensure that the rate would be based on a robust number and value of market transactions in order to be less vulnerable to manipulation (and it was, after all, the manipulation scandal that is causing LIBOR to die this tortured death…). Despite SOFR futures volumes topping $200 billion and 123,000 transactions per day, ARRC has stated that the market is still not sufficiently robust. With the cessation of LIBOR fast approaching, ARRC’s recommendation for the syndicated loan market is to transition away from US Dollar LIBOR to Daily Simple SOFR (or another SOFR in arrears option). These are set out in a User's Guide to SOFR.
Don’t wait, transition now to SOFR
The “don’t wait, transition now” message from ARRC sounds strangely familiar to advice given in the UK market by the FCA in respect of a Term SONIA rate. In January 2020, the Working Group on Sterling Risk-Free Reference Rates (“£RFR WG”) recommended that SONIA, compounded in arrears, was an appropriate option for the majority of the syndicated loan market and this is broadly consistent with recent proposed standards on the use of Term SONIA. Although Term SONIA is currently published, its use is discouraged other than in a very narrow set of circumstances.
There is, of course, no urgency to the situation around US Dollar LIBOR given that it is scheduled to cease for new issuance at the end of 2021 and will continue to be published for legacy contracts until end of June 2023. Although the loan market does need to coalesce around a suitable SOFR convention as the replacement.
With this recent announcement by ARRC, the consensus on both sides of the Pond is to take an “in arrears” approach to calculating SOFR. As interest rates are not set in advance, a short look back period (generally 5 business days) allows interest to be calculated before it is due at the end of the interest period.
Unfortunately, accepted market conventions for SOFR are inconsistent between jurisdictions. The US market is leaning towards Daily Simple SOFR, whereas the UK market has adopted the Compounded SOFR in arrears methodology. The argument in favor of compound interest is that it more accurately reflects the time value of money but utilizing a “simple interest” convention is more straightforward, particularly for secondary market trading. Luckily, with existing low interest rates, the difference between simple and compounded SOFR is typically quite small as an economic matter (if not as an operational matter).
Leveraged loan market
With a jurisdictional divergence, both in terms of timing of transition and market conventions for SOFR between the US and the UK, how should market participants approach loans in US Dollars? Transition from LIBOR linked loans in the leveraged loan market has yet to kick off. Whilst the UK investment grade market is making steady progress, the first publicly marketed “day 1” RFR (SONIA) leveraged finance deal was announced this week. This timing aligns with the sterling market milestone of no new sterling LIBOR linked issuance after Q1 2021. To date, we are not aware of any day 1 SOFR linked leveraged loans.
Multicurrency leveraged finance transactions in the UK market require parties to consider two different approaches. For English law loans, the Loan Market Association has produced documentation which reflects the £RFR WG’s recommendations for sterling - SONIA compounded in arrears. It also suggests that the same approach is taken for US Dollars, namely Compounded SOFR. Will this be problematic at syndication for lenders who typically operate in the US market and thus expect simple interest rather than compounded interest? Additionally, compounded rates may present challenges to the US secondary debt trading market. Some US lenders are requesting the standard US approach of continuing to issue US Dollar LIBOR linked loans with the inclusion of the ARRC hardwired approach which uses Daily Simple SOFR (if Term SOFR is unavailable).
As long as preferred SOFR conventions for US Dollar loans in the leveraged finance market are not yet established, flexibility to transition to either simple or compounded SOFR is essential. In particular, the loan market may still hope for a Term SOFR, even if it is unlikely to be recommended before the end of 2021. Fortunately, the US market currently has a clever “flip forward” drafting mechanism as an addition to ARRC’s hardwire approach, which allows parties to transition to Term SOFR after a transition to another SOFR convention has occurred. Any provision that confers broad flexibility for parties to adopt new SOFR market conventions subsequently, as they become more prevalent in the loan market, can only be advantageous.