On March 5, 2021, the UK Financial Conduct Authority (FCA) announced that the publication of one-week and two-month U.S.-dollar LIBOR would cease after Dec. 31, 2021, and all other U.S.-dollar publication LIBOR settings will terminate or be deemed unrepresentative after June 30, 2023. The Secured Overnight Funding Rate (SOFR) published by the Federal Reserve Bank of New York has been widely promoted as the best alternative to LIBOR, although the adoption of SOFR is voluntary. Other reference rates include the Sterling Overnight Interbank Rate (SONIA), Bloomberg Short Term Bank Yield (BSBY), the U.S. dollar ICE bank yield index, and Ameribor. SONIA is widely used outside the U.S. and has become a standard reference rate used within European credit agreements.

Starting Jan. 1 of this year, regulated U.S. banks will not issue new loans referencing LIBOR, resulting in a systemic shift of new credit agreements to the SOFR benchmark. SOFR is published daily by the Federal Reserve Bank of New York and reflects the cost of secured overnight borrowing and lending in the U.S. Treasury repo market. Although SOFR lacks the historical credit risk and term liquidity premium, The CME Group now provides a forward-looking SOFR --which the Federal Reserve's ARRC has endorsed as term SOFR rates. The five-year historical median difference between U.S. dollar LIBOR and SOFR was used to set the recommended credit adjustments. The ARRC-recommended spread adjustments were set on March 5, 2021, and are 11.448 bps for a one-month tenor, 26.161 bps for a three-month tenor, and 42.826 bps for a six-month tenor.

Fallback language, a contractual provision that specifies a replacement rate or spread adjustment to provide a replacement rate, is now common in credit agreements. The typical benchmark replacement waterfall in new deals, in order of priority, includes (1) term SOFR + benchmark adjustment (2) compounded SOFR + benchmark adjustment (3) relevant governmental body selected rate + benchmark adjustment (4) ISDA fallback rate + benchmark adjustment, and (5) transaction-specific fallback rate + benchmark adjustment. Based on our analysis, term SOFR + adjustment is becoming the preferred benchmark. Credit agreements that have not been amended to reflect the new reference rates will likely fall back to alternative contractual rates, such as prime rate, which is typically more onerous. Some states have enacted a legislative solution to ease the transition. For example, the State of New York has recently passed a law allowing for legacy financial contracts governed by New York law to default to the "relevant governmental body selected rate + adjustment" fallback recommendation. The House of Representatives has introduced HR 4616 to provide a national fallback solution at the Federal level.

S&P Global Ratings' leveraged finance and analytics team has analyzed executed credit agreements syndicated in January 2022 (see summary in table 1). We will continue to monitor this and look to expand our sample set of executed credit documentation over the next few months.

Table 1

The collateralized loan obligation (CLO) market is closely monitoring the benchmark transition to understand better the pricing dynamics of the new risk-free rate and any associated value transfers. CLOs are the largest leveraged loan buyers with approximatively 70% of 2021 new issue flow. The transition away from LIBOR will directly affect CLO payments and returns. More recent broadly syndicated CLO transactions (issued in 2022) have tranches with interest payments based on SOFR while the assets, predominantly leveraged loans issued before 2022, would primarily be LIBOR based, thus introducing some, although limited, basis risk until June 2023. All the legacy loans will also have to transit to a non-LIBOR-based benchmark, likely SOFR. We expect the basis risk to diminish as outstanding loans transition away from LIBOR.

Fallback languages, contractual provisions that lay out the process through which a replacement rate can be introduced, can provide a bridge if the original benchmark is unavailable. Based on our initial assessment, roughly 60% of the S&P Global Ratings' CLO-rated transactions have opted for an ARCC-style fallback language. About 35% of the deals provide managers some limited flexibility, and less than 5% have weaker or no fallback languages. Nevertheless, we expect most to deals to be refinanced or amended before June 30, 2023. ARCC-style fallback language would allow CLO managers to transition to SOFR plus a credit spread adjustment (often following a benchmark transition event or following the breach of an "asset replacement trigger"--which links the timing of the transition of the tranches to the one of the underlying loans to mitigate the basis risk). Managers have slightly more flexibility to pick a new rate in about 35% of our rated universe. These CLO indentures typically have language that was mostly used before the ARCC published its recommended transition language and has the same ultimate goal to reduce basis risk and add transparency). Finally, in the last bucket, less than 5% of CLO managers have no or weaker fallback provisions. However, they could benefit from the change in the New York law that provides a safe harbor to contracts governed by the New York law (which is the case of most CLO transactions).

Looking at historical data, the median difference between three-month LIBOR and three-month SOFR is at 25 bps. However, the gap between the rates tends to widen during economic stresses. Based on our review of the two rates, we have observed that at the onset of COVID-19, LIBOR and SOFR trended in opposite directions for a short period. Differences are expected at the time of a crisis, as a flight to quality will cause a divergence between risky and relatively risk-free rates.

Table 2