In the past few years, the London interbank offered rate (LIBOR) has faced challenges. LIBOR was used deliberately to reflect the cost at which large banks could borrow from each other and for decades was a benchmark for several private-sector rates.
However, the reliability of LIBOR was battered after evidence of manipulation, leading the UK Financial Conduct Authority to call for its eventual elimination. Identifying the need for a replacement benchmark with greater transparency, US financial authorities recently launched the secured overnight financing rate (SOFR).
They believe that SOFR is an upgrade over LIBOR because it is based on interest rates charged in actual lending transactions. In contrast, LIBOR is based on proposals of interbank lending rates by major banks that do not have to be tied to actual transactions, thus making it more vulnerable to manipulation.
After three years of careful study, the Alternative Reference Rates Committee (ARRC) identified SOFR as its preferred alternative to LIBOR, and set 2021 as the target date for LIBOR’s removal. On 3rd April of this year, the Federal Reserve Bank of New York began daily publication of SOFR.
What is SOFR?
SOFR is a secured, overnight funding rate based on a vast range of repo transactions collateralised by Treasury securities. It is considered as one of the most robust indexes available since it is based on a high volume of daily overnight transactions. SOFR offers market participants greater transparency into an important segment of the US financial system - the Treasury repo market.
How has the market responded to SOFR?
During late July, the Federal National Mortgage Association (FNMA) became the first entity to issue a floating rate security benchmarked to SOFR – a worthwhile course of action in the transition away from LIBOR. The market response appeared positive, as the deal was well oversubscribed. Following the FNMA transaction, the World Bank became the second notable issuer to generate a funding deal linked to SOFR. Further to that, several private sector firms have recently followed suit.
In a significant acknowledgement, Standard & Poor called the benchmark an "anchor money market reference rate" making the SOFR index eligible for purchase by money market funds rated by the agency. Furthermore, with the implementation of the SOFR futures market, investors now have a framework for forward-looking expectations and values of the benchmark.
Why is the changeover important to investors?
Currently, LIBOR is the reference rate driving funding costs on a huge volume and variety of financial products. The transition to SOFR hence represents a major change for global financial markets.
The transition from LIBOR to SOFR will be especially relevant for investors in floating rate debt and for issuers seeking variable rate funding. This is because coupons on floating rate notes have historically been set as a percentage amount over LIBOR thus a reliable and credible LIBOR alternative is essential.
A question yet to be answered is how will floating rate notes that mature after 2021 be impacted.
Another important consideration for investors is pricing. For investors to receive the same floating rate yield as LIBOR-based notes, they must demand a higher spread over SOFR to be reimbursed for SOFR's generally lower yields. This differential is due to some important differences in what these rates represent - SOFR is a secured overnight rate, while 3-month LIBOR is longer-term and unsecured.
Looking ahead
Due to the SOFR index being based on a high volume of transactional data in the repo market, it is believed to provide a robust replacement for LIBOR. The recent issuance and acceptance of funding transactions benchmarked to SOFR represent the beginning of the monumental transition away from LIBOR, which has historically served as the reference rate for most floating rate securities.
Although the market is still a few years away from completing the transition from LIBOR to SOFR, the success of recent deals suggests that SOFR will be a welcomed replacement.
Going forward, it is anticipated and desired to have an increase in the adoption and issuance of securities based on SOFR, which would help provide depth to the market. As we approach 2021, investors may be wary of LIBOR-indexed securities as questions and concerns arise over whether LIBOR contributors will continue their voluntary submissions, which could lead to volatility of the LIBOR index.
This article was issued by Maria Fenech, investment manager support officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.