LIBOR to SOFR in the Syndicated Loan Market

Global interest rates change every day. The interest rates used by the bilateral and syndicated loan market are in a period of flux as many market participants are looking for ways to improve the credibility and reliability of benchmark interest rates. Administrative agents are experts at working through these changes. Here are interest rate considerations an administrative agent handles pertaining to the global loan market today.

Interest Rates–Syndicated Loan Market Data

The administrative agent is responsible for periodically setting interest rates for a syndicated loan based on the relevant interest rate benchmark and applicable margin. Interest on most syndicated loans is calculated by combining a floating interest rate based on LIBOR (London Interbank Offered Rate), the prime rate, the federal funds rate, or another widely used benchmark interest rate, plus an applicable margin. Interest rates can fluctuate on a daily, monthly, quarterly or other period as set forth in the credit agreement.

LIBOR and its Function

LIBOR has been the dominant interest rate benchmark for some time.  LIBOR rates are reported every London business day by the Intercontinental Exchange (ICE). LIBOR rates are calculated using the rates reported by a panel of banks with a significant presence in the London market as the interest rate at which they could borrow funds from other banks in the London market. LIBOR is reported for seven different maturities and in five different currencies.

There are problems with LIBOR. The panel of banks providing the rates used to calculate LIBOR are providing subjective rates based on what they believe their cost of funds would be. The financial crisis in 2008 revealed that LIBOR was being manipulated by some of the banks and its reputation has never recovered.

SOFR and the Future

Beginning in 2021, banks will no longer be required to submit the daily rates used to calculate LIBOR. As a result, LIBOR may cease to be available or lose its value as a benchmark rate. Many believe a global standard to ensure financial stability will still be necessary.

The most likely replacement for LIBOR is the Secured Overnight Financing Rate (SOFR). Based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight, it is hoped that SOFR will provide a more accurate representation of the cost of funds incurred by lenders. However, it is still uncertain whether the new benchmark rate will be SOFR or another rate, and if SOFR, how SOFR will be operationalized.

Three Tips to be Prepared

1. Loan market participants should ensure new credit agreements they enter into include fallback provisions that provide a convenient method to select a new benchmark rate if LIBOR is discontinued or becomes unreliable.
2. Existing credit agreements should be reviewed to understand what would happen if LIBOR is not available. In many cases, credit agreements are drafted to provide that the prime rate will be used as an interest rate benchmark if LIBOR is not available.
3. Determine a plan of action for existing credit agreements that do not already include acceptable fallback provisions. The parties may amend the credit agreement to include a replacement benchmark interest rate or provide flexibility by allowing the administrative agent, successor agent or collateral agent to select a replacement benchmark interest rate if and when LIBOR becomes unavailable.