The new Secured Overnight Financing Rate (SOFR) has gained traction recently as a likely replacement for the London Interbank Offered Rate (LIBOR), which is scheduled to disappear by the end of 2021.
Because there are differences between SOFR and LIBOR—a popular reference rate for many floating-rate securities—the transition may have a direct impact on your bond holdings.
It’s important to pay attention to how this process unfolds, so you won’t be surprised if and when these changes affect your investments.
Goodbye LIBOR, hello SOFR.
The transition away from the scandal-plagued London Interbank Offered Rate, or LIBOR, toward its American alternative, the Secured Overnight Financing Rate, or SOFR, has begun to gain momentum. Since July, several large institutions, including the World Bank and Fannie Mae, have issued debt tied to SOFR—key votes of confidence for the fledgling reference rate.
Nevertheless, the shift away from LIBOR—for decades the primary benchmark for short-term interest rates around the world—is likely to raise questions for months to come, and holds some risks for existing investors in LIBOR-tied securities. Although it is scheduled to be phased out by the end of 2021 LIBOR still underlies an estimated $350 trillion in securities across the globe. Because it has long been such a popular reference rate for many investments with floating coupon rates, such as investment-grade floating-rate notes, bank loans and some types of preferred securities, its phaseout may have a direct impact on your bond holdings.
Below, we’ll discuss the details of SOFR, how it compares to LIBOR, and how the transition may affect various parts of the market as the LIBOR phaseout date grows closer.
SOFR’s first steps
SOFR is an overnight borrowing rate that the Federal Reserve Bank of New York began publishing on April 3, 2018, after years of work by the Alternative Reference Rate Committee, a committee that was tasked with developing new rates as concerns grew about LIBOR.1
There’s a long list of reasons why LIBOR fell out of favor, including revelations in 2012 that some member banks had manipulated the rate for their own benefit. Two of the biggest criticisms were the relative inactivity of some of the markets on which LIBOR rates are based (in one example, a LIBOR rate was based on just 15 transactions of a qualifying size for all of 2016) and the subjective nature of the rates, which are set by banks submitting their own estimates of their borrowing costs. SOFR, on the other hand, is calculated using actual transactions, and is considered to be “a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.”2
SOFR has been slow to make its mark in the investment community. In fact, after it was announced that LIBOR would be phased out, many investments with floating coupon rates continued to be issued with LIBOR as the reference rate. Other LIBOR replacement candidates also have been proposed in other countries, including the Sterling Overnight Interbank Average Rate (SONIA), Swiss Average Rate Overnight (SARON) and the Tokyo Overnight Average Rate (TONAR). These rates have been in existence longer than SOFR.
However, SOFR got a boost on July 26, 2018, when Fannie Mae issued $6 billion in floating-rate notes, in three maturities, each with coupons referenced to SOFR—the first-ever SOFR-based securities issuance. A few days later, the credit rating agency Standard and Poor’s (S&P) also offered support: “SOFR is consistent with what it refers to as an ‘anchor money market reference rate’ in its principal stability fund ratings (PSFR) criteria,” S&P announced on July 30. 3
More importantly, according to S&P, investments referencing SOFR would not be classified as higher-risk securities. This has likely helped open the door for corporations, municipalities, and other institutions to start issuing floating-rate securities with SOFR as the reference rate. Since the end of July, the World Bank has issued floating-rate debt tied to SOFR, and so have a few large financial institutions.
By our calculations, since the launch of the SOFR, there have been more than 700 U.S. dollar-denominated bonds issued with floating coupon rates, but only seven have been issued with SOFR as the reference rate.4 While the transition probably will take a while, we believe in time most floating-rate investments will likely be tied to SOFR.
SOFR vs. LIBOR: Key differences
Given its recent launch, there isn’t much historical data for SOFR. But as the chart below illustrates, the rate tends to track the general direction of the federal funds rate, a short-term rate set by the Federal Reserve that governs what banks charge each other for overnight loans.
SOFR has generally followed the lead of the federal funds rate
Source: Bloomberg, using daily data as of 10/12/2018. ICE LIBOR USD 3 Month (US0003M Index), United States SOFR Secured Overnight Financing Rate (SOFRRATE Index) and Federal Funds Target Rate Mid Point of Range (FDTRMID Index).
The transition from LIBOR to SOFR may affect certain floating-rate securities. The coupon rates on floating-rate investments are usually calculated as the short-term reference rate plus a spread to compensate for the additional risks that non-Treasury securities offer. Historically, three-month LIBOR has been the most frequent reference rate for most of these investments, but we believe in the future the coupon rates on many of these securities will likely be SOFR plus some sort of spread.
There are a few key differences between LIBOR and SOFR that could affect investors:
- Because SOFR is secured, it reflects fewer risks than unsecured LIBOR. SOFR is based on the cost of borrowing when that borrowing is collateralized by Treasury securities, and therefore reflects fewer risks than unsecured rates. Because LIBOR rates are unsecured, they tend to be higher than secured rates, to reflect counterparty risk.
- Most LIBOR rates are longer than the SOFR rate. There are many different LIBOR rates, ranging from as short as overnight to as long as 12 months, although three-month LIBOR is the most commonly used benchmark. SOFR, on the other hand, is a single overnight lending rate. Because SOFR is an overnight rate and three-month LIBOR has a three-month maturity, SOFR likely would be biased lower. All else being equal, shorter maturities tend to have lower yields.
SOFR is an overnight rate and has tended to be lower than three-month LIBOR
Source: Bloomberg, using daily data as of October 12, 2018. United States SOFR Secured Overnight Financing Rate (SOFRRATE Index) and ICE LIBOR USD 3 Month (US0003M Index).
Taken together, and assuming constant spreads, a SOFR-based floating-rate investment would likely have a lower coupon rate than a comparable three-month LIBOR-linked floating-rate investment. The difference may be minor—likely measured in basis points, not percentage points—but there is a difference nonetheless.
We view the recent SOFR-linked bond issuance as a positive development regarding the transition from LIBOR to SOFR. However, there are still many investments—or even consumer loans—outstanding that are still linked to LIBOR rates, many with maturities beyond the year 2021, when LIBOR is expected to go away. For many existing floating-rate investments we reviewed, there is no concrete language in the prospectuses that lays out a plan if a given reference rate no longer exists. Recently issued floating-rate investments that are still referenced to LIBOR have generally included language about the LIBOR phaseout, but there still tends to be some flexibility about what actually happens once a LIBOR rate is no longer available.
Additionally, there could be risk for existing investors of floating-rate notes. If corporations begin to issue floating-rate notes with a new reference rate, seasoned floaters that are still tied to LIBOR may be less desirable and could potentially experience a loss of liquidity. In the bond market, lower liquidity usually means a wider gap between what a bond can be bought or sold for, and typically leads to more price volatility. This could negatively affect holders of these types of investments.
What to do now
We still think investments with floating coupon rates can continue to help investors as short-term interest rates rise. While we do see some risks with the ongoing implementation of SOFR, we view the recent new issuance linked to SOFR as a positive development. We think it’s important to pay attention to how this process unfolds so you won’t be surprised if and when these changes affect your investments.
1Source: New York Federal Reserve.
2Source: New York Federal Reserve. The rate is calculated as a volume-weighted median of transaction-level tri-party repo data collected from the Bank of New York Mellon as well as GCF Repo transaction data and data on bilateral Treasury repo transactions cleared through FICC's DVP service, which are obtained from DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation
3Source: Standard and Poor’s, “The Secured Overnight Financing Rate (SOFR) is Consistent with Our Principal Stability Fund Ratings Criteria,” July 30, 2018.
4Source: Bloomberg, as of 10/12/2018.