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As the transition away from US dollar (USD) LIBOR continues, market participants continue to evaluate such as the discontinuation of USD LIBOR and CME Group’s recommendation of forward-looking Secured Overnight Financing Rate (SOFR) forward rates (Term SOFR) as a replacement USD LIBOR, impacts credit facilities and other agreements. A key variable that remains in focus is spread adjustment.
As USD LIBOR is generally higher than Term SOFR, a spread adjustment concept has been introduced to make Term SOFR more economically equivalent to USD LIBOR. The five-year historical median difference between USD LIBOR and SOFR was used in setting the recommended spread adjustments and as a result it was expected that the spread adjustments recommended by the Alternative Reference Rates Committee (ARRC) would result in the maturity SOFR rates close at USD LIBOR during “normal” interest rate periods.
However, as we noted in our article last fall, the spread differences between USD-LIBOR and Term-SOFR at this point were significantly smaller than the spread adjustments recommended by the ARRC due to historically low interest rates. As a result, using the ARRC-recommended spread adjustments (contained in ARRC’s hard-coded fallback language) would have resulted in a replacement rate that would have been higher than would have been the case if the USD-LIBOR tenor SOFR -Real-time spot differences would have been used. Market participants recognized this disparity and in many cases opted for spread adjustments that were smaller than the spread adjustments recommended by ARRC.
However, as interest rates rise, USD-LIBOR maturity SOFR spot spreads are approaching the ARRC-recommended spread adjustments, as seen in the table below.
|1 month||3 months||6 months|
|Spread adjustment recommended by ARRC||0.11448%||0.26161%||0.42826%|
|Average September 2021 USD LIBOR Term SOFR Differential1||0.031074%||0.065232%||0.095718%|
|Average September 2022 USD LIBOR Term SOFR Differential2||0.088304%||0.128256%||0.230284%|
Sources: https://www.cmegroup.com/market-data/cme-group-benchmark-administration/term-sofr.html and https://www.wsj.com/market-data/bonds
With the US Federal Reserve expecting more rate hikes, USD-LIBOR-Term-SOFR spot spreads are likely to widen further.
As USD-LIBOR Term SOFR spot spreads approach ARRC recommended spread adjustments, the parties may reevaluate the spread adjustments used in their agreements, particularly those agreements that previously included a lower spread adjustment. The parties may elect to fully utilize the ARRC recommended spread adjustments or another set of spread adjustments and may allow for a transition period to phase in to selected spread adjustments. Parties can also forego spread adjustment, although as interest rates rise, creditors will likely be reluctant to adopt this approach without some other economic adjustment (e.g., an increase in applicable margin).
The parties should evaluate whether changing the spread adjustments makes commercial sense and ensure that the documentation is amended to provide the desired fallback rate prior to the USD LIBOR discontinuation.
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1. Average calculated using prices from September 13th to 17th, 2021
2. Average calculated using prices from 26th to 30th September 2022
The content of this article is intended to provide a general guide to the topic. In relation to your specific circumstances, you should seek advice from a specialist.
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