From the start of 2022, the newly originated SOFR-based credit agreements have included a mixture of different credit spread adjustments. On one side of the spectrum there are credit agreements that do not appear to add any credit spread adjustment to the Term SOFR rates. On the other side of the spectrum, some credit agreements have adopted the ISDA- and ARRC-recommended credit spread adjustments. The other two most popular options picked by market participants are: (i) adding a flat 0.10% credit spread adjustment across all interest periods; or (ii) adding 0.10%, 0.15%, and 0.25% credit spread adjustments for one-month, three-month, and six-month interest periods respectively. The flat 0.10% credit spread adjustment is more frequently adopted in investment grade or other “pro rata” credit facility agreements that are largely not traded in the secondary loan market. The formulation that includes 0.10%, 0.15%, and 0.25% credit spread adjustments for one-month, three-month, and six-month interest periods respectively is more frequently adopted in leveraged loan credit facility agreements than investment grade credit facility agreements. It is worth noting that if we reference the June 23, 2022, data, both the flat 0.10% and the 0.10%, 0.15%, and 0.25% credit spread adjustment formulations would lead to lower interest rates for borrowers across each of one-month, three-month, and six-month interest periods.
It remains to be seen if, after the LIBOR transition period has ended, some credit agreements will continue to reference a credit spread adjustment to SOFR or whether margin pricing will simply evolve to take into consideration a SOFR benchmark instead of a credit sensitive benchmark.
Interest Period Variations
The ARRC endorsement of the 12-month CME Term SOFR rate on May 19, 2022 resolves one of the open questions of whether or not parties to a credit agreement could include a 12-month interest period. The remaining interest periods that are frequently included in LIBOR-based credit agreements but are not published by the CME as Term SOFR interest periods are one-week and two-month term rates.
With respect to a two-month interest period, we have not seen SOFR-originated credit agreements that include this interest period. For those credit agreements that originated using LIBOR and included a two-month interest period, administrative agents could interpolate the two-month interest period rate using the published one-month and three-month LIBOR rates if permitted pursuant to the terms of the credit agreement. Those credit agreements that contain certain ARRC-based LIBOR transition mechanics allow the administrative agent to remove the two-month interest period. The earlier credit agreements that did not include such a mechanic are still likely not to include the two-month interest period in the LIBOR transition amendment agreed by the parties. Many administrative agents have already notified borrowers that two-month interest periods are not available under their facilities as of the end of 2021.
With respect to the one-week interest period, there have been a few SOFR-originated credit agreements that have retained a quasi-one-week interest period. The most common alternatives used in the market either allow the borrower to make interest payments weekly using the Daily Simple SOFR rate or use the one-month Term SOFR published rate as the reference for the one-week interest period. Failing these mechanics, a borrower could still prepay and reborrow the loan on a weekly basis, but this option can only be used in revolving credit facilities and the borrower risks incurring breakage costs as well as having to remake the representations and warranties in the credit agreement each week upon the new drawing. For LIBOR-based credit agreements, the ability to interpolate a one-week LIBOR rate will depend on the wording of any interpolation mechanics. The results are likely to be similar as with respect to the two-month interest period with the one-week interest period most frequently dropped.
Trading Mechanics of SOFR-Based Loans and the Secondary Trading Market
Historically, secondary trading of loans in the institutional market has been evidenced using the LSTA forms of Confirmation (whether the LSTA Distressed Trade Confirmation or the LSTA Par/Near Par Trade Confirmation), and recently a similar form has been developed by the LSTA for primary allocations (the LSTA Primary Allocation Confirmation) (collectively referred to as “LSTA Trade Confirmations”). Each of the LSTA Trade Confirmations incorporates a Standard Terms and Conditions document that, among other terms, includes a concept for when and how interest on a loan that is earned by a lender may be passed to a prospective lender during the period of time that passes after the parties have agreed to trade the loan but before such loan trade has settled. This concept includes a defined term for “Cost of Carry,” which has historically used LIBOR to calculate what is owed among the parties.
As noted above, since the start of 2022, both new syndicated credit agreements that evidence the loans that are being traded, as well as the indentures that evidence the notes that are used by the institutional lenders to fund themselves, are using SOFR to calculate interest. In line with this move to SOFR, the LSTA updated the LSTA Trade Confirmations and related Standard Terms and Conditions on December 1, 2021, to reference Daily Simple SOFR instead of LIBOR. This change more closely aligns the secondary trading documents with the relevant credit agreements.
Remediation of Legacy LIBOR Credit Agreements
On March 5, 2021, the Financial Conduct Authority (the “FCA”) announced the future cessation or loss of representativeness dates for the 35 LIBOR settings published by the ICE Benchmark Administration. The two key dates in the announcement were December 31, 2021 (after which all the interest period tenors for GBP, EUR, JPY and CHF LIBOR and the one-week and two-month interest period tenors for USD LIBOR either cease or lose representativeness), and June 30, 2023 (after which the remaining USD LIBOR interest period tenors would cease or lose representativeness).
The immediate impact of the March 5, 2021, FCA announcement was that a trigger in the ARRC-based LIBOR replacement mechanics was met and that all agreements referencing non-USD currency LIBOR rates should have been replaced or amended by December 31, 2021. As a result, the fourth quarter of 2021 included a lot of LIBOR replacement amendment activity with respect to the non-USD currency LIBOR rates. Some credit agreements referencing non-USD currency LIBOR rates were not immediately amended but instead a “suspension of rights” letter was delivered by the borrower in those credit facilities that acknowledged and agreed that the borrower would not borrow the non-USD currency loans until such time as the non-USD currency LIBOR rates were replaced.
With the non-USD currency LIBOR loans generally remediated, the focus from the beginning of this year and through June 30, 2023, shifts to USD LIBOR loans. The first six months of 2022 have seen a number of existing USD LIBOR loans remediated to SOFR through “organic” means such as refinancings or repricings. In those cases, given that either new lenders provide the financing that refinances the existing credit facility or 100% of the existing lenders have to vote to amend the agreement, the fallback mechanics of the existing credit agreement are irrelevant, and parties may negotiate and agree to their preferred benchmark rates, credit spread adjustments, etc. A primary purpose of the extension of the USD LIBOR cessation date of most tenors from December 31, 2021, to June 30, 2023, was to allow a greater portion of facilities to naturally transition to reduce the number of outstanding contracts which had no or inadequate fallback language.
The ARRC has recommended that, where feasible and appropriate to the circumstances, parties remediate their contracts ahead of USD LIBOR cessation. These proactive remediation efforts, rather than relying on the mechanics of the fallback language, may have a number of benefits for parties. We have not seen a great deal of consensual USD LIBOR replacement amendments to date. However, it is generally expected that this replacement process will increase in velocity through the second half of 2022 and into 2023, although that velocity will presumably be impacted by the then-current interest rate environment and how incentivized a borrower is to transition from USD LIBOR.
On June 21, 2022, the LSTA released different forms of benchmark replacement amendments that may be used by the market participants as they remediate their legacy USD LIBOR credit agreements. The forms are drafted to provide for either: (i) a “golden amendment” that contains in it all the relevant SOFR-based terms and definitions and is meant to apply to any type of credit agreement, no matter what defined terms of which sections of the existing credit agreement contains the relevant LIBOR provisions that are replaced; or (ii) a “cover amendment” with an annex, which is meant to be a redline of the existing credit agreement that shows the changes made to the agreement to replace LIBOR with SOFR (whether Term SOFR or Daily Simple SOFR). The advantage of using the “golden amendment” form is that the transaction costs for amending the credit agreement are much lower as the same form may be used for many credit agreements. However, a future amendment and restatement of that credit agreement may prove more challenging, as might properly cross-referencing sections in related loan documentation. As for the “cover amendment” with redline approach, the upfront costs of amending would be higher as each amendment is bespoke and follows the existing credit agreement. However, it is easier down the line to amend the agreement again and/or to follow where the new provisions are in the agreement.