Less than five months before Libor is phased out on June 30, term SOFR is emerging as a preferred benchmark for US dollar loans in Asia given its similar characteristics to its predecessor.
Like Libor, term SOFR, which was introduced in July 2021, is forward-looking, making the cost of borrowing easier to calculate using data available at the start of the interest rate period.
By comparison, compounded SOFR, which was preferred in the early days of the transition away from Libor, is losing its appeal as it is backward-looking. Interest calculations in compounded SOFR-linked loans take place near the end of the interest period, making the cost less predictable for borrowers.
"While both methods continue to be available, the market has clearly gravitated to term SOFR in recent months, with lenders demonstrating a strong preference for term versus compounded SOFR in the current interest rate and cost of funds environment," said Amit Lakhwani, head of loan syndicate for Asia-Pacific at Standard Chartered.
Indonesia’s BFI Finance has launched a US$100m three-year facility paying an interest margin of 150bp over term SOFR, following in the footsteps of other deals from Asia that use the benchmark. They include a US$1.2bn five-year loan for a solar power joint venture between state-owned China General Nuclear Power Corp and China Southern Power Grid, a US$400m–$500m three-year loan for China Ping An Insurance Overseas (Holdings) and a US$1.2bn two-year borrowing for SCB X, a newly created unit of Thailand’s SCB Financial Group.
In December, CIMB Bank closed its largest syndicated loan – a US$735m 5.25-year facility – that was the first from Asia to offer participating banks the option to use either term or compounded SOFR as a benchmark. At the close of syndication, participating lenders accounting for US$710m of the deal opted for term SOFR, while the rest chose the compounded alternative. Syndicating the deal in that manner allowed CIMB to tap a wider liquidity pool.
Room for error
Term SOFR’s appeal is understandable as it is far simpler and more straightforward to compute, whereas compounded SOFR requires investment in people and technology.
“If you are willing to invest to calculate that compounded overnight rate, that is great,” said a Singapore-based senior loan banker at a Japanese bank. “But for us it is still very manual. Although Excel is powerful enough to generate such rates, there is a fair bit of data entry involved, which can potentially lead to human error.”
According to Ernest Koh, senior associate at law firm Ashurst, term SOFR is “just a lot easier to implement, and you are not introducing full schedules to the facility agreement. If you were to introduce daily compounded, usually you would have three new schedules, and for two of them you have mathematical formulas on how the rate is compounded – so that can be optically intimidating to borrowers.”
Nonetheless, there are barriers to the widespread adoption of term SOFR, such as the need to apply for one or more licences from US financial derivatives exchange CME Group, which is the benchmark administrator tasked with calculating the rate.
Data security concerns
Certain financial institutions, particularly Chinese banks, have been slow to sign up for the licence because of concerns over the cross-border flow of sensitive information to the US, which could potentially impinge on data security and privacy laws, market participants say.
“If mainland Chinese banks are expected to participate in the syndicate we have seen a delay in adopting term SOFR due to the fact that many may not have signed a licence agreement with CME,” said David Lam, a partner at international law firm King & Wood Mallesons. “To overcome this, it is essential that mainland Chinese banks fully understand their reporting obligations as licence holders, and get comfortable that such reporting obligations do not fall foul of their obligations under relevant PRC laws and regulations.”
Compounded SOFR holds an appeal for some borrowers as the base rate is currently lower than term SOFR by approximately 10bp–20bp. Being forward-looking, term SOFR tends to reflect potential base rate increases much quicker, which matters in the current tightening cycle at the US Federal Reserve. Bankers note, however, that this cuts both ways.
Hedging costs
Another challenge for term SOFR is that it is relatively less liquid in the derivatives market, potentially leading to higher hedging costs. Borrowers may prefer to use compounded SOFR as a result.
“Liquidity could become an issue if a term SOFR loan needs to be hedged,” said Ashurst’s Koh. ”If a hedging bank wants to provide an interest rate swap for a loan, it would typically have to enter into back-to-back arrangements in the market and that is where term SOFR is currently not as liquid as daily compounded SOFR.”
Some borrowers are still leaning towards compounded SOFR for those reasons. For example, Shandong provincial government-owned conglomerate Shuifa Group’s US$200m debut three-year sustainability-linked loan pays an interest margin of 200bp over daily compounded SOFR.
On the other hand, some deals do not explicitly specify term or compounded SOFR in the invitation letters to prospective lenders. Chinese internet giant Sina’s US$400m 364-day term loan launched in early January is one example. The deal pays a margin of 145bp over SOFR.
Arrangers of syndicated loans are coming up with flexible solutions for borrowers and lenders that cannot choose either term or compounded SOFR for whatever reason.
"We're seeing more borrowers pick term SOFR over daily compounded SOFR because it is more predictable, but some deals ended up adopting the latter as most onshore Chinese banks participate [in] deals with daily compounded SOFR," said Phyllis Ng, head of syndication for transaction banking and capital market at China Construction Bank (Asia). "There has been a case where we saw a separate compounded SOFR tranche to accommodate lenders that are unable to use term SOFR. It all depends on where the borrowers need to draw liquidity from."
(Additional reporting by Apple Li)