Transitioning to Term SOFR
At the beginning of 2021, most lenders who had already adopted a SOFR index were using either NY Fed 30D SOFR (compounded SOFR set in advance) or daily simple SOFR (a simple average of the daily resets). While these rates certainly do the trick, markets still longed for a forward-looking term rate similar to LIBOR. Enter Term SOFR.
Term SOFR has been in the works for some time but picked up momentum in late July 2021 when the ARRC formally recommended it for use. Following that announcement, banks began to develop financial models and work through approvals to offer derivatives indexed to Term SOFR, which is seen as a preferred benchmark replacement for LIBOR, with the first Term SOFR cap being traded in November 2021 (by team Pensford!).
Changes To the Economics
When comparing LIBOR and Term SOFR indexed caps, there are only a couple minor differences.
Business Days for Resets
USD LIBOR is typically determined using London Business Days whereas Term SOFR generally uses US Government Securities Business Days.
- The latter is defined as “any day except for a Saturday, Sunday, or a day on which SIFMA recommends that the fixed income departments of its members be closed for the entire day for purposes of trading in U.S. governmental securities based on the SIFMA calendar”.
In most cases, the same standard two day lookback period used with LIBOR still applies with Term SOFR.
Initially, Term SOFR caps carried a minor premium of around $5k. However, we’ve seen recent Term SOFR caps trade at prices in line with, or in some cases slightly cheaper than, other equivalent SOFR or LIBOR structures.
Thus far, the cost to modify from LIBOR or another SOFR index to Term SOFR has been nominal, with most trades costing around $5k.
Modifying an Existing Cap
If you’re looking to modify an existing cap based on LIBOR or another SOFR rate to Term SOFR, there are a few steps:
Banks need to update their KYC checks prior to modifying. In most cases this requires little effort from the borrower but sometimes an updated W9 or the latest version of a Dodd-Frank bilateral will need to be submitted.
If the hedge was a lender requirement and collaterally assigned, banks typically need written consent from the lender to make any modifications.
Similar to the initial cap placement, once onboarding is complete and consents (if required) are submitted, we’ll all need to hop on the phone with the bank to complete the modification.
For borrowers who traded LIBOR based caps on or after 1/25/2021, or for those who have already adhered to the 2020 IBOR Fallbacks Protocol, these transactions will fall back to ISDA SOFR (compounded SOFR + spread). For more ISDA SOFR, check out our white paper here.
For non-Agency borrowers who traded caps before 1/25/2021 and have not adhered to the ISDA Protocol, eventually some action will need to be taken if the cap maturity goes beyond 6/30/2023. This action would likely come in the form of adhering to the 2020 IBOR Fallbacks Protocol (read more here) or a modification of the hedge to another index. In either case, we would look to the loan docs and seek insight from the lender prior to taking any action.
While all SOFR rates generally shake out to be around the same, a mismatch between the index used on the loan and hedge could fail to meet the lender’s hedge requirement. In most cases we would expect any basis risk between the indices to be minimal, but if you do need to modify a cap, the good news is the process is relatively simple with a nominal cost.