SOFR-Linked Risk Spreads

SOFR is structurally different

Term SOFR is a near-risk-free rate, secured by US Treasury collateral and observable through actual transaction volume. LIBOR, by contrast, embedded a credit risk component — bank-to-bank unsecured borrowing — that disappears entirely under SOFR. The implication is that any all-in coupon must explicitly carry the credit-risk premium that was previously bundled inside the benchmark itself.

The credit spread adjustment

Most legacy LIBOR facilities transitioned at a fixed Credit Spread Adjustment — approximately 11 bps for one-month and 26 bps for three-month tenors — added to Term SOFR to preserve economic equivalence. New originations no longer carry the CSA as a separate line; instead, the lender's quoted spread internalizes the equivalent risk premium plus their own funding cost.

Spread architecture

• Base benchmark: Term SOFR at the contractually defined tenor (typically 1M or 3M).
• Lender funding spread: The cost of bank or fund capital relative to the risk-free rate.
• Asset-class risk premium: A structural spread reflecting collateral type, jurisdiction, and enforcement regime.
• Sponsor / leverage premium: A deal-level spread reflecting LTV, DSCR cushion, and sponsor track record.

Hedging considerations

Floating-rate exposure should be evaluated against the project's income volatility and the borrower's equity cushion. Institutional practice is to hedge a defined fraction of outstanding debt — often 50–75% — through SOFR caps or swaps with strikes calibrated to the DSCR breakeven. Caps preserve upside if rates fall; swaps deliver certainty at the cost of optionality. The choice is a function of the borrower's broader portfolio rate exposure, not the standalone deal economics.