To hear certain company-side organizations, borrowers are ready for alternative rates―if only their lenders would offer them.
So far, much of the focus has been on getting lenders to stop originating LIBOR loans in favor of loans based on alternative, risk-free rates. As we get closer to that becoming a reality on a broad scale, it’s worth taking a look at the issue from a borrower’s perspective. Borrowers have no say in the phaseout of LIBOR, but to varying degrees they will have a say in which alternative rates will become prevalent in the market.
To hear certain company-side organizations, borrowers are ready for alternative rates―if only their lenders would offer them. On April 27, 2021, the Association for Financial Professionals, the National Association of Corporate Treasurers and the U.S. Chamber of Commerce joined in a letter addressed to Secretary of the Treasury Janet Yellen, Federal Reserve Chair Jerome Powell, New York Federal Reserve Bank President John Williams, SEC Chair Gary Gensler and CFTC acting Chair Rostin Behnam to provide their views on the challenges posed by LIBOR transition. All three organizations are members of the Alternative Reference Rates Committee of the New York Federal Reserve Bank (ARRC) and participate in the ARRC’s Non-Financial Corporate (NFC) Working Group, which represents large and small Main Street businesses across the country.
Leaving aside the operational, technological, accounting, tax and legal challenges that they face, two-thirds of NFCs surveyed by the group “struggle in obtaining from their lenders specific proposals and processes for how their loan agreements will be amended and the mechanics of how the ARRC’s recommended SOFR rate will substitute for LIBOR.” In particular, “many banks are not yet offering SOFR-based loans,” and even large, well-capitalized NFCs are “unable to negotiate current access to SOFR borrowings, even with large multi-year credit agreements nearing renewal.” Among the concerns of the group is that “by the time the banks have fully prepared transition materials and processes, the NFCs awaiting that information would have little to no time to rework contracts and internal compliance and technological systems.”
Assuming that alternative reference rates are available in the very near future, what should a borrower do? Although the letter does not give any particular guidance, it provides some useful insight into the perspective of Main Street companies. Considering that the letter is written by members of the ARRC and is addressed to regulators that have been uniform in their support for the ARRC, it is not surprising that the writers are “committed to assisting you in ensuring a successful transition from U.S. dollar LIBOR to SOFR as the far more robust reference rate.”
But in this case, the failure of the letter to request alternatives to SOFR is more deliberate. In discussing the drawbacks of LIBOR, the letter points to the “volatility and unreliability” (emphasis added) of LIBOR, where hundreds of trillions of dollars of loans and derivatives may be based on as little as $500 million of interbank transactions. The letter goes on to state that “[t]his orders-of-magnitude difference becomes even more unbalanced for LIBOR and other credit-sensitive rates during times of financial market stress, when transaction volumes shrink while rates spike up, causing a spiral of increasing unreliability.” (Emphasis added.)
In case this language isn’t clear enough, the writers attached an appendix that shows the results of a survey done of borrowers. When asked the question “would you prefer to borrow using alternatives based on SOFR or potential credit-sensitive rates that could move up like LIBOR has done in times of economic stress?” (emphasis added), roughly 85 percent of borrowers chose SOFR and about 15 percent preferred credit-sensitive alternatives.
The wording of the question is more than a bit leading, but the information is telling. For the most part, borrowers have been sitting on the sidelines so far since it is up to the banks to come up with the replacement rate they are planning to charge borrowers. With the participation of the letter writers on the ARRC, the SOFR rate selected by the ARRC is quite favorable to borrowers. As shown in item 12 of the ARRC’s FAQ from April 27, 2021, 90-day average SOFR has generally been less volatile than three-month LIBOR, even during times of “financial market stress.” On any particular day, SOFR may spike up, but on an average basis the rate is more stable.
By its nature as a rate based on secured transactions, SOFR is generally lower than an unsecured rate like LIBOR. To make the rates approximately the same, the finance market has agreed on the spread adjustment to be added to SOFR to achieve the comparable LIBOR rate—0.11448 percent for a one-month tenor, 0.26161 percent for a three-month tenor and 0.42826 percent for a six-month tenor. It’s not perfect, but it provides a fixed basis of comparison. The spread adjustment is in addition to any margin for the borrower’s credit. In any event, market participants are free to negotiate the spread. In a competitive market, where borrowers have market data, this may favor borrowers. There is also some thinking that in a rising rate environment, as is projected in the next few years, the stable, secured SOFR rate may go up relatively less than the comparable LIBOR rate may have gone up if it were still around, even taking into account the fixed spread adjustment above. No one has a crystal ball, but SOFR seems like a relatively safe bet for borrowers.
If a borrower is currently using a daily LIBOR rate, then daily simple SOFR should be roughly comparable. Daily simple SOFR is generally operational now.
Since SOFR swaps will be using a compounded SOFR rate, some borrowers, particularly real estate borrowers, may prefer to use compounded SOFR for their loans. There is still some basis mismatch between loans and swaps due to the slightly different ways that compounded SOFR loans and compounded SOFR swaps will be calculated. However, hedge providers maintain that the difference is relatively small, and that the mismatch is also inherent in current swaps. Lenders are just starting to get their compounded SOFR documents and systems in place, but compounded SOFR loans should be available soon.
For borrowers that prefer to manage their interest rate exposure with certainty through one- or three-month fixed LIBOR rates, forward-looking Term SOFR with comparable 30- and 90-day fixed interest periods should be available by the end of July or days thereafter. For lenders, Term SOFR is operationally very much like LIBOR, so it should be available shortly after it is formally recommended by the ARRC. There are no Term SOFR swaps yet, but they should develop quickly once Term SOFR loans are up and running.
In contrast to SOFR, the alternative replacement rates are all unsecured, credit-sensitive rates, born of the concern from lenders that a secured rate will not adequately compensate them for their cost of funds during times of market stress or a rising rate environment, or if they are unable to access the secured overnight financing market. Everything else being equal, borrowers can be expected to resist a rate that may spike up in an unpredictable way during times of market stress or as credit markets tighten.
However, the answer may not be as easy as “just say no.” A lender that might prefer to lend based on BSBY may offer a comparable SOFR loan, but at a relatively higher margin over the rate. Or a regional lender may offer Ameribor at a lower margin compared to the rate that a national lender may offer for a SOFR loan, having increased the SOFR margin to compensate for its credit risk. The LIBOR spread adjustments described above only apply to SOFR in comparison to LIBOR. In a world where LIBOR is no longer available, such spread adjustments are meaningless.
What is a “good” rate for an Ameribor or BSBY loan compared to a SOFR loan? Statisticians can crunch the historical data, but this will likely remain a challenge for borrowers and lenders to navigate. More choices should be good news for borrowers. A lender that wants to succeed in the market with rates other than SOFR will need to sell its product to its customers, and apparently convince them that credit sensitivity does not mean volatility. For reference, we provide useful information on Ameribor and BSBY in some of our prior Alerts.