Over the course of the next several months, participants that are actively engaged in project financing will need to begin thinking about how to manage the transition away from the London interbank offer rate (LIBOR, known as the “most important number in finance”). LIBOR forms the basis for many financing agreements. LIBOR is scheduled to be phased out by market regulators in December 31, 2021, and many large banks and investment managers have been busy preparing for this fundamental shift. The Federal Reserve’s Alternative Reference Rate Committee (ARRC) selected the “Secured Overnight Financing Rate” (SOFR) as the successor rate to LIBOR. SOFR is certainly the leading candidate to replace LIBOR, although there are other alternative rates that are also “competing” to replace LIBOR, such as American Financial Exchange’s “Ameribor” and ICE’s “Bank Yield Index.” (These non-SOFR rates may be available to borrowers, but this depends in large part on whether an active market in pricing non-SOFR loans develops between now and the end of 2021.)
SOFR is in certain respects fundamentally different from LIBOR. Thus, the transition will not necessarily be as simple as replacing one interest rate with an equivalent fallback rate. For instance, one structural difference is that SOFR does not currently have a forward-looking term structure like LIBOR, meaning that it is backward-looking (calculated in arrears). If a liquid derivatives market based on SOFR develops before the end of 2021, then SOFR may develop a forward-looking term structure – but, until that happens, participants may find this feature to be one of the most significant operational differences between LIBOR and SOFR . Further, SOFR is a secured overnight rate, whereas LIBOR is an unsecured rate with various tenors. Fundamentally, this means that LIBOR has an implicit credit component that SOFR does not have – which means that the adoption of SOFR as a replacement rate will need to incorporate a credit spread adjustment that effectively replaces LIBOR’s implied credit component.
From a documentation standpoint, LIBOR transition will require the modification of existing loan agreements that reference LIBOR, in addition to any interest rate swaps that are based on the rate. This means that projects with debt plus a hedge will need to think about any switch to SOFR as a “package,” with a primary goal of ensuring that the interest rate hedge remains stable and tightly aligned with the terms of the project debt. If a project sponsor only hedges a portion of the notional of the project debt – effectively carrying a certain amount of floating rate exposure – then the unhedged portion will be based on SOFR.
To this end, on October 23, 2020, the International Swaps and Derivatives Association (ISDA) published a protocol addressing the upcoming transition, which was one of the final major pieces of the puzzle that the market needed to see in order to begin taking steps to transition the derivatives market away from LIBOR. On the loan side, the Loan Syndications and Trading Association (LSTA) recently published a concept credit agreement that utilizes SOFR. We will be publishing additional content on LIBOR’s phase-out in the future; in this initial post we hope to flag that this upcoming shift in the debt market’s financial plumbing is one that participants that are actively financing (or refinancing) projects should be aware of.