Assessing the Term Rate Menu

John recently updated the case for alternative US term rates, focusing on the emerging alternatives to compounded SOFR. Market evolution has seen at least six rather new alternative offerings emerge, all of which provide welcome, forward-looking competitors to compound or Term SOFR.

In this blog I add to John’s work by sharing some of our questions and listing some of the distinguishing features that make these evolving rates all subtly different. I also look at some of the recent pricing relativities, using the period of market stress generated by the Ukraine-Russia conflict.

We believe market participants need to understand the new offerings, particularly since, as John noted, turning a whole market from LIBOR to compounded SOFR is not without challenges, and for some a transition to backwards looking rates may not even be possible.

Questioning the Menu

Use of the Swedish ‘smorgasbord’ as a metaphor for the emerging alternatives to compound or simple risk-free-rates was very deliberate in my blog of October 2021.

The point?

Financial markets are proving different post-LIBOR; moving from the familiar, ubiquitous, and operationally simple system that LIBOR delivered, to a multi-rate environment, with a menu that includes the opportunity to avoid heightened credit sensitivity if one wishes to do so.  

So, what is on the term rate menu?

At Martialis, we’ve followed the evolution of the menu with great interest from the ring-side seats of the consultant. Our part is not played as end-users, and we’re not financial product providers. Properly, we are benchmark agnostic, but we have been watching this space closely and from our vantage-point the need to amplify our call for end-users to better understand the new array of benchmarks continues to be real.

Questions

Distilling our view is best achieved by recounting some of the various questions we have raised ourselves, or that clients have raised and to which we’ve responded.

What follows is not an exhaustive list but are those we feel are of salient importance.

QUESTION: Under LIBOR the credit margin for any given credit was easily distinguished, simple to convey, and readily comparable among adjacent credits. Borrowers were easily able to compare quotes in any RFQ. In a multi-rate system, where each benchmark has distinctive characteristics within a mix of credit sensitive and insensitive alternatives, how do firms properly assess the price of a distinctive credit?

This appears almost impossible to answer at present. Markets will likely take time to adapt and settle within the multi-rate environment, and we can’t discount the possibility that a particular benchmark may eventually become dominant.

What we know is that some providers continue to lean on the ISDA Credit Adjustment Spread methodology to engineer a LIBOR-like base, essentially placing a transition-tool fixed spread based on a quite aged fixed five-year lookback of LIBOR-OIS basis.

It seems to us unlikely for this to continue indefinitely. Bank funding costs are a moveable feast, as the COVID and Ukraine war credit-stress events so ably reminded us (see graph below).

What we fear is a dilution of pure credit risk may take hold. Any blurring of the lines between sector credit risk and individual credit price is a bad outcome. Efficient capital allocation is not advanced in a system in which credit risk is blurred.

QUESTION: We are seeing some use of Term-RFR plus the fixed BISL spread across corporate finance; does that mean borrowers are realising some inherent advantage exists?

It may be that a perceived advantage exists, and the attraction of Term-RFRs has both an operational dimension (they’re relatively easy to implement), as well as a ‘credit insensitivity’ dimension.

This may prove illusory in the longer run, since banks themselves face variable funding; a reality that can’t easily be ignored ad-infinitum. If an extended period of more expensive bank funding were to emerge it is hard to see how a RFR or Term-RFR plus historic fixed spread could be sustained.

Consequently, we believe some interesting ‘credit’ pricing outcomes could emerge, for example it is possible that for realised yield outcomes the following may hold in some cases, and possibly persist in some markets:

(Term-RFR + Margin X) = (Term-CSRx* + Margin Y),

where Margin X > Margin Y

Note: CSRx = some Term Credit Sensitive Rate.

If this condition were to become common, it would imply that investors/lenders and/or the sell-side were willing to discount credit margins where customers elected to accept a credit-sensitive benchmark. This is a topic we intend to explore in a coming blog.

QUESTION: SOFR Academy (who partnered with Invesco Indexing as administrator) recently published prototype rates of their Across the Curve Credit Spread Index, or AXI, a dynamic credit-spread ‘add-on’ to SOFR. Could the use of such add-ons become common-place?

Note: Any prospective user of AXI that would intend to also use CME Term SOFR in developing an interest rate for Cash Market Financial Products or OTC Derivative Products would require a license with CME Group for use of CME Term SOFR.

Rather than pass comment on an individual alternative, I decided to ask the CEO of New York based SOFR.org, Marcus Burnett, for his thoughts on this question.

CEO Burnett: I think the vast majority of institutional liquidity will go to SOFR, whether compound, simple, or Term-SOFR, and recent data tends to support this.

It’s important to note that AXI can be applied to any variation of SOFR, so end-users have quite wide degrees of freedom as to the underlying convention that best suits them.

In launching AXI we will not create a path for banks to skip over SOFR, which is a key distinction between our offering and other credit-sensitive alternates. A loan that references AXI will also reference SOFR, so AXI is supportive of the SOFR-First initiative. 

We believe SOFR plus a higher overall credit margin has the potential to be higher than SOFR + AXI + Credit Margin because banks have to include an insurance premium for their funding costs when the credit spread is embedded within an overall margin. Borrower margins traditionally only increase due to credit events such as a ratings downgrade.

We note that such an add-on affords users to retain their link to what we might regard as the official sector’s preferred rate (SOFR).

Which encourages us to think there is a long way to go before markets settle on a particular favourite, but credit add-ons present a particularly interesting dimension, and we cannot exclude major banks favouring their use. If syndicates were to follow-suit, a period of heightened market credit stress might forge their lasting use.

We’ll continue to monitor this topic with interest.

For those interested in the movement of various USD term rates through the Ukraine war credit stress event, I have taken simple daily benchmark rates and plotted them for Q1, 2022.

It’s interesting to note the relative stress differences, and to highlight these I simply use max-min to give an indicator of comparative credit stress.

We intend to look at credit stress events in greater detail in a coming blog but leave readers to draw their own conclusions on the interesting relative credit sensitivity evidenced here.

For those who’d like to receive a copy of our up-to-date Term-Rate summary paper, please e-mail us at info@martialis.com.au to request a copy.