Term SOFR: six months on
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In May 2022 we reported that where Term SOFR was being used widely in U.S. loans; its use in other markets was more limited. Six months on, how has the picture changed?
First, a quick recap.
Term SOFR is a forward-looking term rate, available on a screen for periods of 1, 3, 6 or 12 months. It is derived from futures trading in SOFR, which represents the cost of overnight borrowing in the U.S. Treasury repo market. Term SOFR became widely available in July 2021 when it was recommended by ARRC (the U.S. Alternative Reference Rates Committee, a group of private-market participants convened by the Federal Reserve Board and the New York Fed) as part of the strategy to move away from LIBOR. At the same time, ARRC updated its best practice recommendations to support the use of Term SOFR for business loan activity.
In the cash markets the main alternatives to Term SOFR are Compounded SOFR (generally used in EMEA) and Daily Simple SOFR (more popular in the U.S.). Those rates are also derived from SOFR, but on a backward-looking basis: they take the value of SOFR each banking day during an interest period, and accumulate daily interest to determine the overall interest applicable to an interest period. The major difference to Term SOFR, though, is that with Term SOFR the interest rate is calculated at the start of the period, but for Compounded and Daily Simple SOFR the amount of interest can only be calculated when the interest period is nearly over. 
The main advantage of Term SOFR is clear: borrowers know at the start of an interest period what their interest payment will be, and operationally Term SOFR works in a familiar way, similar to USD LIBOR (and other IBORs, including EURIBOR). As a result, Term SOFR has been enthusiastically adopted in the U.S. loans market, and the majority of new deals are now based on Term SOFR rather than Daily SOFR or Compounded SOFR.
However, outside the U.S. there has been a slower take-up. We are seeing more of Term SOFR, but Compounded SOFR remains popular, and in many markets Compounded SOFR remains the predominant benchmark for U.S. dollars.
Is Term SOFR being used outside the United States?
In the UK and mainland Europe, adoption of Term SOFR differs significantly between corporate/investment grade lending and in leveraged finance. In the corporate world, while there are increasing numbers of Term SOFR transactions, they are still quite few in number. In general, borrowers have got used to Compounded RFRs and see no reason to change.
In leveraged finance, by contrast, most new deals use Term SOFR. Sponsors propose Term SOFR in the term sheets which are sent to lenders, and we have perceived no reluctance by lenders to accept this; there is no real discussion of the topic. So it seems that when borrowers ask for Term SOFR, UK and European banks are happy to offer it.
The situation is similar in Asia. More and more deals are being proposed with Term SOFR, but Compounded SOFR dominates.
In the Middle East and Africa, however, the majority of new transactions are now based on Term SOFR. We are even seeing some existing transactions, which moved to Compounded SOFR during LIBOR transition, now adopting Term SOFR instead.
What is holding Term SOFR back?
Where Term SOFR is not being widely used, why is this – and more importantly, do we think those reasons will continue to stand in the way of Term SOFR?
The main obstacle is probably inertia. Borrowers which use GBP, CHF and JPY had to amend their loan documents in the past two years, before panel-bank LIBOR for those currencies ceased on 31 December 2021. And when moving from LIBOR to RFRs for those currencies, almost all borrowers would also have amended USD LIBOR benchmarks – and at the time, the only available solution for USD was Compounded SOFR. Unsurprisingly borrowers have limited appetite for another amendment process for existing documents, and on refinancings they tend to keep to the existing documents unless there is a good reason to change.
On the other hand, LIBOR transition for USD-only loans is only taking place now, because panel-bank USD LIBOR will continue to be published until June 2023. USD-only borrowers therefore have the choice between SOFR and Term SOFR, and in the US at least, most are choosing Term SOFR.
For borrowers which draw GBP and borrow from UK-regulated lenders, there is a further reason why Compounded SOFR is easy to accept. Although a forward-looking rate for GBP exists (Term SONIA), the UK authorities have concerns about how robust Term SONIA can be (as a derivative rate) if the loans market were to move away from the underlying rate of SONIA. UK regulators have therefore discouraged the use of Term SONIA except for certain specific situations, which do not include large corporate borrowers in the loan markets. As a result, large sterling loans are generally benchmarked to Compounded SONIA, and if treasury teams have to cope with the mechanics of one compounded rate, they may not perceive any issue using compounded SOFR for USD.
For borrowers which draw EUR and USD, the opposite argument applies – so it is surprising not to see more enthusiasm for Term SOFR in the eurozone. EURIBOR, the predominant benchmark for borrowing euros, is a forward-looking rate. A proposed fallback rate to EURIBOR (EFTERM) is also a forward-looking term rate, based on futures trading in €STR (just as Term SOFR is based on overnight SOFR). Borrowers which only draw EUR and USD (and not GBP) can therefore use forward-looking rates consistently across their debt, and in time we expect this will lead to increased take-up of Term SOFR by European borrowers.
One final drawback of Term SOFR is that although ARRC has recommended the use of Term SOFR derivatives for end-users (i.e. borrowers), it recommended that derivatives between dealers (i.e. banks and other financial markets players) should be based on overnight SOFR, not Term SOFR – which means that dealers offering Term SOFR to borrowers cannot lay off that risk precisely by back-to-back market trades. Borrowers wishing to hedge loans based on Term SOFR may therefore find their dealers lack appetite for Term SOFR derivatives, and wider availability (and better pricing) can be found for overnight SOFR hedges. We have heard anecdotally that this has influenced some corporates to borrow (and hedge) using Compounded SOFR rather than adopt Term SOFR.
One other drag on Term SOFR outside the U.S. has been the lack of generally accepted market documentation – but that is no longer an issue, as robust and practical documentation now exists for Term SOFR.
The LMA’s first exposure draft for Term SOFR (released on 27 October 2021) was useful as a reference point, but was not widely used in the EMEA loans market – partly because it was based on emerging markets documentation and not appropriate for investment grade loans, and partly because it provided only for a single currency so needed significant work to be used for multicurrency facilities.
A new multicurrency exposure draft was released on 12 October 2022, and has been much better received. This new exposure draft is based on the LMA investment grade template with its modular approach to benchmark rates, providing a schedule setting out reference rate terms for Term SOFR (just as there are schedules to slot in for SONIA, EURIBOR, Compounded SOFR, etc.). The draft also contains optional language for credit adjustment spreads for use with term rates, and some additional fallbacks. Although this is an exposure draft and not a recommended form of the LMA, in practice we expect it to be widely used.
Term SOFR is here to stay, and we expect it to become more popular over time, and even to become the predominant benchmark for U.S. Dollars ahead of Compounded SOFR. There is a well-established calculation methodology, regulators appear to have given Term SOFR the green light, there are advantages for borrowers, and it is straightforward to document.
The increasing adoption of Term SOFR will highlight the contrast with the UK regulatory stance against Term SONIA for use in mainstream corporate lending. It will be interesting to see how (if at all) the UK regulators react to this. We will report back on that, and generally on the continuing development of Term SOFR.
A&O at the forefront of RFR developments
Allen & Overy has led the way on advising clients on their transition from LIBOR to new risk free rates, including advising on pioneering deals for: (1) Royal Dutch Shell plc – the first syndicated loan agreement in the European loan markets to incorporate SOFR; (2) British American Tobacco plc – the first ever multicurrency syndicated loan to include provisions for SOFR and SONIA; (3) Tesco plc – the first syndicated facility agreement that referenced both SONIA and SOFR from the date of signing; and (4) GlaxoSmithKline plc – the first large scale credit facilities to be linked from its commencement to both SONIA and SOFR compounded in arrears.
CME Term SOFR was actually launched in April 2021, but ARRC only approved the 1, 3 and 6 month tenors in July 2021, and subsequently approved 12 month CME Term SOFR.
For more information on the calculation of SOFR, see: https://www.newyorkfed.org/markets/reference-rates/sofr#:~:text=The%20SOFR%20is%20calculated%20as,U.S.%20Department%20of%20the%20Treasury's
Certain tenors of sterling and Japanese yen LIBOR have been made temporarily available on the basis of a synthetic calculation methodology after December 2021 for those products that weren’t able to transition in time. These synthetic rates will disappear in stages over the next two years.
The US regulators, in contrast to their UK colleagues, have imposed no such restrictions on Term SOFR.