A SOFR floor is a contractual safeguard that shifts interest rate risk between borrower and lender. In private credit and direct lending, these clauses ensure lenders retain a minimum cash yield even when benchmark rates fall.
When the floating base rate drops below the agreed floor, borrowers continue paying interest as if the benchmark were still at that floor level. It’s a simple mechanism with significant implications for all-in lending rates and portfolio yield stability.
Think of floors as insurance that lenders embed in loan agreements. When the Secured Overnight Financing Rate falls toward zero, as it did in 2020, the floor kicks in to protect lender returns. The borrower pays the higher of observed SOFR or the floor, plus the agreed margin.
The economics are straightforward. Consider a 500 million dollar facility with a 475 basis point margin and a 50 basis point floor. If three-month Term SOFR averages 10 basis points over the life of the loan, the borrower pays 5.25 percent instead of 4.85 percent – a 40 basis point penalty for the entire balance.
The penalty compounds once you add fees. With a 2 percent original issue discount amortized over 24 months, the effective cost rises from about 5.85 percent to roughly 6.25 percent. In practice, the floor impact mirrors a 40 basis point margin increase.
Lenders value this protection because it stabilizes net interest margins in a falling-rate cycle. Instead of watching yields compress as benchmarks decline, they maintain a minimum return threshold. Floors prove most valuable during extended low-rate periods – exactly when credit portfolios face margin pressure.
Most credit agreements calculate the base rate as Max(observed SOFR, floor), then add any credit spread adjustment, and then the margin. The ordering matters for borrower cost and lender yield.
Market practice applies floors to the underlying benchmark before adding the credit spread adjustment. If Term SOFR is 30 basis points, the floor is 50 basis points, and the credit spread adjustment is 10 basis points, the base becomes 60 basis points. The floor does not cap at 50 basis points and then add the CSA – doing so would shortchange the lender.
Documentation also governs how floors persist through benchmark fallbacks. If Term SOFR becomes unavailable and the loan falls back to Daily Simple SOFR, the same floor typically continues unless the agreement says otherwise. That persistence prevents accidental economic shifts during benchmark transitions.
Private credit facilities usually reference either CME Term SOFR or Daily Simple SOFR compounded in arrears. The reference rate affects how floors operate in practice and how cash flows behave.
With Term SOFR, the floor applies to a single observed rate for the entire interest period. If three-month Term SOFR is 25 basis points and the floor is 50 basis points, the calculation uses 50 basis points for the full quarter.
With Daily Simple SOFR, the market usually applies the floor to the period average rather than each daily rate. This approach reduces operational complexity while keeping economics close to the intended result. The differences are typically measured in basis points unless rates move sharply within a period.
SOFR floors are rarely isolated points of negotiation. Sponsors and lenders trade them against margins, OID, or covenant flexibility to achieve the desired pricing balance.
For example, a 50 bps floor might justify a 25 bps margin reduction if forward curves indicate that the floor will bind often. Conversely, if rate cuts appear unlikely, borrowers may concede higher floors for better covenant terms or reduced upfront fees.
The trade-off depends on the expected hold period and interest rate path:
Sophisticated sponsors model scenarios explicitly, testing how various floor levels affect all-in cost under different rate paths. They evaluate whether to accept a slightly higher margin with no floor or opt for a lower margin paired with protection.
Ultimately, the decision reflects how much interest rate risk each side is willing to hold or hedge away.
SOFR floors can complicate hedging strategies for borrowers using interest rate swaps or caps. A standard pay-fixed, receive-floating swap references actual SOFR, not the floored rate in the loan agreement.
Example: A borrower has a 50 bps floor on its loan and enters a swap when Term SOFR sits at 300 bps. If SOFR later falls to 25 bps, the borrower’s loan interest is calculated using 50 bps, while the swap pays only 25 bps. This 25 bps gap creates a mismatch, and the hedge no longer fully offsets the floating exposure.
The fix: structure receive-floors in hedge confirmations to align with the loan’s floor. Dealers can price these embedded options, making the hedge economically consistent. Without them, borrowers often end up paying a higher effective fixed rate than intended.
Many credit agreements require matched benchmarks and reset conventions in hedges but overlook floors. That omission can prove costly when the rate cycle turns downward.
Not all floors are created equal. The level and structure often depend on credit size, quality, and leverage.
Some facilities specify different floors by reset tenor, though the added complexity rarely changes economics materially. Most apply a single uniform floor across all interest periods.
Interest calculations follow a set sequence each period. First, select the benchmark – Term SOFR for the chosen tenor or Daily Simple SOFR averaged over the accrual period. Second, apply the floor to determine the base rate. Third, add any credit spread adjustment. Fourth, add the margin to arrive at the all-in coupon.
Administrative agents run these mechanics per the credit agreement. The calculations typically finalize two business days before the payment date.
In facilities with PIK toggles, floors still apply to the cash interest component. The floor does not disappear because a portion of interest capitalizes. It continues to affect the base rate used for both cash and PIK interest.
MFN clauses typically govern margins in incremental or repricing facilities, but many ignore floors. That oversight can leak value.
For instance, if the original tranche has a 50 bps floor and 475 bps margin, but a new tranche adds 500 bps margin with no floor, the borrower might achieve better all-in pricing under falling rates while still complying with a margin-only MFN.
To protect returns, lenders should draft MFN provisions that include both margin and floor terms. Borrowers, naturally, resist such language, yet the asymmetry becomes meaningful when rates drop in syndicated loans or club deals.
Floors function like options that lenders receive. Their value depends on the probability and depth of rates falling below the floor during the expected life of the loan.
When forward curves price meaningful cuts, floors become valuable and lenders push for them. When curves are flat or rising, floors offer little expected benefit and are easier to concede.
The option value depends on interest rate volatility, time to expected prepayment, and the spread between forward rates and the floor. A 50 basis point floor has substantial value if forwards sit near 25 basis points for 12 to 18 months. The same floor adds little value if forwards remain above 150 basis points.
Private credit investors can model these scenarios and trade floors against other terms accordingly. The key insight is that floors deliver concentrated value in specific rate environments rather than steady value across all conditions.
Adjusting floors post-origination is rarely straightforward.
In secondary markets, loans with higher floors often trade at premiums when rate cuts loom, offering superior downside protection and more predictable yield. Timing matters: once the market clearly anticipates rate cuts, amending floors becomes costly and contentious.
Setting the right level at origination prevents these mid-cycle disruptions.
Investment committees should track exposure to floors versus unprotected floating-rate risk. Floors change income sensitivity and stress outcomes compared with standard floaters.
At the fund level, report floor protection explicitly. It shapes how portfolio income responds to policy changes. A portfolio with 50 percent floored facilities behaves differently than one with standard floaters when central banks cut rates.
Complexity rises when loans mix Term SOFR and Daily Simple SOFR across tranches or allow the borrower to switch conventions. Floor mechanics should follow the benchmark consistently to avoid disputes.
Fallback language is critical if benchmark administrators change methodologies or cease publication. Floors should persist through replacement mechanisms rather than disappearing during transitions.
Cross-border facilities may reference SONIA or EURIBOR. Confirm that floor mechanics translate appropriately across benchmarks and jurisdictions.
Portfolio risk models should incorporate floor effects when measuring interest rate sensitivity. Floored loans protect the downside but still participate in rising rates. That asymmetric payoff changes effective duration and convexity at the portfolio level.
Run stress testing where floors bind for extended periods alongside scenarios where floors remain out of the money. Floors tend to deliver the most protection during credit stress, when rates usually fall and spreads widen.
Under U.S. GAAP and IFRS, embedded floors in floating-rate debt are typically not bifurcated as separate derivatives because they are closely related to the host instrument. They factor into the effective interest rate when future cash flows can be estimated.
Hedge accounting requires decisions about whether the hedged risk includes or excludes the floor. Effectiveness testing must reflect floors if they are part of the hedged relationship, which usually means adding a matching receive-floor to the hedge instrument.
Make floor decisions early in the documentation process. Week one should cover benchmark selection and floor level analysis using forward curves and expected loan life. Week two should lock down contract language and calculation mechanics. Week three should finalize hedge implications and confirmation requirements.
Late-stage floor changes disrupt syndication, documentation, and hedging. It is better to set appropriate floors at origination than to amend once market conditions move.
Beyond standard haggling over levels, a few structure tweaks can preserve economics for both sides with less friction.
Both sides should evaluate the trade-off between margin and floors with consistent assumptions. Use scenario analysis to compare value across interest rate paths and expected prepayment.
SOFR floors in private credit are straightforward in definition yet powerful in effect. They redistribute interest rate risk, stabilize lender yields, and meaningfully influence all-in borrowing costs.
When thoughtfully negotiated, hedged correctly, and transparently modeled, SOFR floors serve their purpose: ensuring rate risk is shared efficiently between sponsors and lenders, without surprises once the rate cycle turns.
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