Term SOFR execution charges in interest rate hedges

Post the June 30, 2023 LIBOR "sunset" date, borrowers have gotten comfortable with SOFR-indexed loans, liquidity for hedges on SOFR is now robust, many lenders are in the process of transitioning legacy LIBOR loans to SOFR, and legislation has been passed which ensures that legacy LIBOR loans and hedges will automatically convert to SOFR if not otherwise amended.

The emergence of a Term SOFR “basis” which impacts hedging costs for CRE loans indexed to Term SOFR (the predominant version of SOFR used in non-Agency CRE debt) has been a challenge, post-LIBOR. This basis has its roots in restrictions on interdealer trading of Term SOFR derivatives. While dealer banks can offer Term SOFR caps and swaps to CRE borrowers, they themselves can’t hedge their own risk with Term SOFR derivatives in the interbank market. This forces them to hedge their risk using derivatives indexed to an alternative version of SOFR (typically SOFR compounded in arrears). These versions of SOFR can diverge. When this divergence occurs, a dealer’s hedge isn’t perfectly effective, resulting in basis risk held on the dealer’s book. Dealers must reserve against this risk by charging CRE borrowers more for their hedges.

This pricing impact is more pronounced in interest rate swaps. We’ve observed dealer banks providing swaps on Term SOFR charging an additional 3-6 basis points in the swap rate depending on the bank and the swap structure. There is a pricing impact for interest rate caps as well, expressed as an additional charge, in dollars, which can be larger or smaller depending on how “in-the-money” the cap is (i.e., how low or high the strike rate of the cap is relative to the SOFR forward curve). Unfortunately, these pricing impacts are not consistent between banks and currently can’t be verified through any third-party data providers, though the recent change in regulatory guidance permitting dealers to trade Term SOFR-SOFR basis swaps with non-dealers may change that.

In practice, this affects CRE borrowers that are putting new hedges in place or that are restructuring legacy LIBOR hedges as follows:

• Swaps on new loans indexed to Term SOFR and modifications of legacy LIBOR swaps will typically be subject to a 3-6 basis point execution charge that would not be observed with an alternative version of SOFR. This results in a higher all-in coupon on the loan relative to alternative versions of SOFR.
• Premiums on new caps indexed to Term SOFR or costs associated with converting legacy LIBOR caps to Term SOFR will include a component attributable to this basis risk. The exact amount will be driven by the size and tenor of the cap and how high its strike rate is.

In this context, we are advising clients as follows:

• Please contact us for any new financings, or any conversions of legacy LIBOR financings that involve caps or swaps so we can help you evaluate the potential impact of Term SOFR execution charges on deal economics.
• For new financings involving a swap, or conversions of legacy swapped LIBOR floaters to SOFR, it will typically be economically advantageous to use daily SOFR (rather than Term SOFR) as the loan index.
• For new financings involving an interest rate cap, the choice of daily SOFR or Term SOFR will usually be less impactful.
• In situations where a legacy LIBOR loan with a cap is being converted to Term SOFR, a borrower should consider the pros and cons of incurring the expense to convert the cap to Term SOFR relative to letting the cap fallback to SOFR compounded in arrears (per standard ISDA fallback provisions). The former approach ensures a perfect hedge, but may come with a conversion cost; the latter may have a lower conversion cost, but will create a mismatch between the SOFR index used in the loan and the cap. This may cause the cap to be an imperfect hedge in situations where there is a divergence between spot SOFR expectations as implied by Term SOFR and actual spot SOFR rates.