Credit Sensitivity Perspectives

The transition to multi-rate benchmarks was always going to raise some fundamental questions regarding post-LIBOR deal pricing.

In this blog I take a closer look at simple proxies for USD credit sensitivity using historic data available at the St Louis FED. The findings are quite consistent with what we should expect intuitively, but in contracting for new deals it’s worth considering the historic path of credit sensitivity and whether exposure to it is advantageous.

We believe participants need to understand the new offerings. The availability of both credit sensitive and credit insensitive offerings makes this somewhat more important, since those found to have accepted an unnecessary path run the risk of being challenged to explain their reasoning.

Historic credit sensitivity

There are many different approaches to identifying periods of financial-sector credit stress. In this piece I have chosen to rely on a very simple proxy stress measure; the historic difference between USD AA-rated commercial paper (CP) of financials and the corresponding CP of AA-rated non-financials at the 3-month tenor.

(FinCP – NonFinCP) = FCP Indicative Risk Premium

 The data I’ve used comes courtesy of the repository kept by the St Louis FED, which is an excellent source for those interested in this kind of analysis.

Intuitively, the interest rate spread between AA-rated financials and non-financials should track quietly between extended periods of stability and periods of intense fluctuation in which the yield of financials jumps relative to that of non-financials.

And this is the historic pattern over the past 25 years of the data, which I’ve displayed below. I have labelled some of the key events of that time.

Which is consistent with the picture of the typical market stress measure used by dealers:

(LIBOR – SOFR OIS) = Indicative Risk Premium

Using the slightly shorter dataset available for 3-month USD LIBOR versus SOFR OIS (as implied by the FED’s Term-SOFR proxy).

I then compare the various standard statistics of the indicative risk premia, the results of which are displayed in the following table:

We find that 3m LIBOR exhibits a consistent margin above AA financial paper, at an average +21.3 BP, which is +13.7 BP higher than AA bank funding spread (as defined by 3-month financial CP) through time.

In periods of market stress LIBOR’s excess premium jumped as high as +89.5 BP in 2008, coincident with the excessive market stress event of the Lehman Brothers collapse of October 2008 (the GFC).

Replicating this with the LIBOR – SOFR OIS spread we find the excess premium somewhat more pronounced and more volatile.

Incidentally, in looking at the 3-month LIBOR – SOFR OIS data (term-versus-term rates) the five-year mean of rates to March 5th, 2021, is slightly different to the ISDA Credit Spread Adjustment announced that day; 28.2 BP versus 26.1614 BP for the ISDA. This is due to the difference between the SOFR compounded in-arrears calculations of the ISDA (backward-looking) versus the implied Term-SOFR of the SOFR-OIS rates used here (forward-looking).

Major stress events mapped

To identify historic market stress events consistently, I search for periods of more than single days where 3m financial rates exceeded non-financials by one standard deviation or more (i.e., greater than +23.6 BP (7.6 + 16.0 BP)).

The following bar graph looks more like a commercial bar-code, but each blue period is an individual stress period identified using this approach.

The dominant stress events of the GFC bouts (both 2007, and 08) are clearly shown.

Stress since 2006

Across the 25 years of St Louis FED data there have been 11 credit stress events using this simple measure, however only 10 of these seem viable.

Viable?

The stress event of the March-May 2020 COVID shock froze US commercial paper markets at a time when the FED was easing rates very aggressively, resulting in a very brief inversion of the normal stress indicator (because CP rates lagged the FED move). I have therefore chosen to ignore the 2020 COVID ‘event’ as an obvious false flag.

Statistics from the ten viable/real stress events for our financials versus are presented in the following table:

With the resulting simple averages:

When we compare the excess premium during periods of market stress to the simple averages of excess for the full data set, it suggests 3-month USD LIBOR carries between +8.7 and +13.8 BP of additional premium compared to basic CP funding.

Interestingly, for the early period of the data (the credit stress free 1997-2006 period) the average financial less non-financial spread was +3.2 BP (10 BP lower than the average of the entire 25 years). From 2006, in a foretaste of the GFC stress, a sector-wide repricing of bank risk commenced.

Credit sensitivity acceptance

What does all this tell us?

For those seeking or willingly accepting rate exposure to a LIBOR-like replacement for USD LIBOR the data analysed here is worth more than passing comment:  

·         LIBOR credit sensitivity has consistently exceeded that of identified financial minus non-financial credit spreads, at an average premium of +13.7 BP to CP since 1997, and +17.7 BP to risk-free (SOFR OIS) since 2001.

·         During periods of market stress, historically of 47 business-days duration, the LIBOR minus CP premium has averaged +22.4 BP,

·         During those same periods the 3-month LIBOR minus SOFR OIS premium averaged +31.5 BP.

·         As past FED studies have indicated, it’s not clear that LIBOR has reliably tracked actual bank funding.

·         New reference rates such as Ameribor, AXI, BSBY and CRITR/CRITS may behave differently compared with each other and LIBOR because they are based on different inputs.

While we remain benchmark agnostic with good reason, it’s worth the parties to new deals understanding these facets of credit-sensitivity, and at least asking whether exposure to it is advantageous.

Summary – what does this mean for me?

Averages are often quite misleading and ignore the extreme events and the impacts on us and our actual outcomes. Stress events in markets, as described above, can be defining moments and have significant implications.

We firmly believe that firms should consider:

·         the impact of extreme market events and the implications for funding and/or returns;

·         the choice of reference rate and whether this is appropriate for their needs; and

·         planning for extreme market events and how their choice of reference rate will be likely to perform.

With more choices for reference rates and the high likelihood of markets diverging from averages periodically, our work with clients has focussed on the impacts and strategies to manage the financial implications.