By John Hintze
Building a market consensus on a forward-looking SOFR.
Because it’s stable and less apt to be manipulated, the Secured Overnight Financing Rate (SOFR) is attractive to treasurers, but corporate borrowers continue to want the traditional term structure to manage their cash flows.
Efforts to provide a forward-looking replacement for Libor, the longstanding floating-rate benchmark, are continuing but have yet to produce an ideal substitute index, according to Tom Deas, chairman of the National Association of Corporate Treasurers (NACT), NACT’s representative on the Federal Reserve’s Alternative Reference Rates Committee (ARRC), and a retired treasurer of FMC Corp, who described options to foster a term structure.
In April 2018, the Federal Reserve Bank of New York began publishing SOFR, generated daily from upwards of $800 billion in repurchase-agreement (repo) transactions, and soon after the CME launched SOFR futures contracts. Those contracts, and eventually SOFR swaps, will be necessary to build an indicative SOFR curve over which to price loans. However, trading volume in those derivatives has so far lagged, and SOFR remains an overnight rate.
Andrew Bailey, who heads London’s Financial Conduct Authority (FCA), charged with supervision of Libor, has warned he cannot ensure submitting banks will continue to provide Libor’s necessary components beyond year-end 2021. That’s the same deadline set by the ARRC, a group of private-market participants convened by regulators to ensure a successful transition away from US dollar Libor, to create a robust term SOFR generated from the developing SOFR derivatives market.
That’s cutting it close, Mr. Deas said, adding, “It’s like going right up to the edge of a cliff and hoping the bridge will be built by the time we get there.”
Mr. Deas said that corporate treasurers support a risk-free rate such as SOFR because it should remain relatively stable in financially stressful environments, unlike today’s Libor, which spikes in times of stress. As an overnight rate, however, SOFR is not a direct replacement for Libor, which is typically quoted for one-, two-, three-, six- and 12-month terms.
Mr. Deas said that can complicate companies’ cash-flow calculations, and that most corporate treasuries’ systems are set up for term rates. Consequently, over the past few months he has been promoting the return of competitive bid lines (CBLs) to generate market determinations for a forward-looking SOFR curve.
Corporates used CBLs in the 1980s and 1990s when they saw improvement in their credit ratings and wanted tighter credit spreads on drawdowns than their revolving credit agreements stipulated. Instead of marketing a new syndicated loan, paying upfront fees and taking the market risk of a new syndication, a borrower with a CBL in its revolving credit agreement could notify the loan’s administrative agent and request, say, $100 million over three months.
The administrative agent would then conduct an auction among the lenders participating in the revolver, which could then bid the spread over Libor they were willing to provide. The borrower would then fill out the $100 million with the lowest-cost spreads.
In the context of SOFR, Mr. Deas said, a corporate borrower could similarly request bids from lenders on the spread over SOFR they’re willing to accept to make a loan. In the three-month example, the borrower would agree to pay lenders the compounded-in-arrears SOFR rate over that period. It may be willing to take that risk of not knowing what the final rate will be until the end of the term, or it could call banks’ derivative desks to swap the in-arrears rate for a fixed one.
“The interest-rate-swap bank would pay me SOFR in arrears for the next three months—matched to the loan—and I’ll pay it a fixed rate that it tells me at the loan’s inception. I’ll sign up for that derivative,” Mr. Deas said. “In addition, that would start to create liquidity—the fixed rate for three months would be the market determination for what the forward-looking SOFR would be.”
“That solution could create a virtuous cycle leading to liquidity and trading, and ultimately a vibrant market in forward-looking term SOFR rates,” he added.
Such a solution would require banks to reestablish desks to make those bids, and ultimately competitive bid lines give corporates the chance to get a better rate than the spread in their credit agreements, a change that banks may resist.
Alternatives to SOFR have also been proposed. Regional banks have expressed concerns about a risk-free rate such as SOFR dropping to zero or below in times of stress, when investors may seek safety in overnight repos, and corporates subsequently drawing down their revolvers.
The ICE Benchmark Administrator (IBA), which publishes Libor, launched a proposal in January addressing such concerns by creating a benchmark derived from banks’ wholesale primary funding transactions and reflecting their cost of funding, which is likely to increase in stressful periods.
The submissions, a much broader array than Libor’s, would include interbank deposits and institutional certificates of deposits. IBA updated its Bank Yield Index (BYI) proposal in July by putting that “credit spread” over an indicative term SOFR similar to what two Federal Reserve economists described in a recent paper.
Mr. Deas said that treasurers have taken great care, especially since the financial crisis, to structure their companies’ bank groups with the strongest, most creditworthy banks that would be most likely to continue funding them during a crisis.
The BYI, however, “seeks to measure the average yields at which investors are willing to invest in the unsecured debt obligations of a broad set of large, internationally active banks for specified forward-looking tenors,” he said, and many of its contributing banks may hold lower ratings than the banks a large, investment-grade corporate borrower would have in its bank group.
Consequently, the BYI’s proposed credit spread may be higher on average than a corporate borrower’s selected group of banks, and it would likely jump in stressful periods, perhaps more than Libor.
“If you’ve selected your bank group that way, why would you want to use an index reflecting submissions from banks that could be much weaker than that?” Mr. Deas said.
One solution may be to customize a bank-yield index to reflect the cost of funds of a company’s own syndicated bank group, plus the company’s credit spread, he said, adding such an index would have to be constructed on the fly and there would be administrative challenges.
However, in times of stress the Fed will likely keep its rate low or even cut it.
“So that should be reflected in the banks’ cost of funds, not just the cost of other sources, such as CDs and CP,” Mr. Deas said.