Developments in USD Reference Rates

I have commented in the past on the emergence of alternatives for compounded SOFR in the USD market. Just as a reminder, compounded SOFR is the recommended replacement for USD LIBOR where the daily SOFR rate compounds this over a specific period and the rate is calculated a few days (typically 2 or 5) prior to the end of the relevant period.

As James Lovely pointed out to me in my previous blog, I neglected to mention Ameribor in my list of alternatives which will be corrected here! My reasoning at the time was that the target user base for Ameribor was quite different to the Martialis blog reader base but it should be included for completeness.

Current alternatives to compounded SOFR

Certain users of reference rates who have traditionally referenced the soon-to-be-discontinued USD LIBOR, can have requirements which do not naturally lend themselves to compounded SOFR. Turning a whole market from LIBOR to compounded SOFR is not without challenges and this transition may not be possible for some users.

The case for alternatives is very real for many users.

Here are the current alternatives (in alphabetical order):

1. Ameribor (AFX);

2. AXI (SOFR Academy);

3. BSBY (Bloomberg);

4. CRITS/CRITR (IHS Markit);

5. ICE Bank Yield Index (ICE BYI);

6. Term SOFR (CME); and

7. Term SOFR (ICE).

Right now, Ameribor and Term SOFR (CME) appear to be well supported with the other options still developing. 

Firstly, let’s have a quick review of the features of the alternatives.

In general, there are 2 categories of alternative: risk-free and credit sensitive. Of the 6 alternatives above, only the Term SOFR is risk-free.

Risk-Free, Term SOFR 

A risk-free rate does not include appreciable credit risk. SOFR, and therefore Term SOFR, is a secured lending rate with minimal credit risk.

In many cases, this is a particularly appropriate rate for users. For example, a corporate borrower can set the risk-free reference rate against an observable and defined rate (I.e., one which is close to the Fed target rate) and effectively pass on the liquidity and credit risk to the lender.

Any variations in the actual funding rate will be absorbed by the lender if it differs from the risk-free rate. Depending on the maturity and type of lending product, the cost or benefit will be priced into the lending rate and could be expected to reflect the risk to the lender.

For example, a 3-year bullet loan would simply include the known cost of funds that the lender could access for that maturity and principal. However, a revolving credit facility where the principal and term of the funding are not typically defined when the contract is negotiated, would have to price the uncertainty of the timing and amount of the loan as well as the potential market liquidity at the time.

While the risk-free rate may provide more certainty for the borrower, it may come at a price which reflects the risk to the lender in the product.

Credit Sensitive Rates

LIBOR has a credit and liquidity component embedded in the rate. Look at the USD LIBOR – SOFR spread since early March! It has moved up 30+ basis points. That is credit and liquidity in action.

The other non-SOFR rates have moved up as well and partly replicate LIBOR in performance. While they still replicate LIBOR much more closely than Term SOFR or compounded SOFR there are some differences. We will come back to this in later blogs.

The dynamic nature of the credit and liquidity spread within the credit-sensitive rates may make them attractive to some users. After all, LIBOR did have a use for over 30 years and did not attract any realistic competitors.

Ameribor, AXI, BSBY, CRITS/CRITR, ICE BYI and AXI are all variants of credit-sensitive reference rates. They all manage to include the same aspects of LIBOR which tracked actual market rates but ground the rates in actual transactions (unlike LIBOR).

It is this connection to the ‘real’ world which makes credit-sensitive rates attractive for some users. It is relevant to borrowers and lenders as the credit and liquidity pendulum swings both ways. Sometimes credit-sensitive rates benefit borrowers (e.g., the past 2 years where the LIBOR – SOFR spread was at a relatively low level) and lenders (e.g., now where LIBOR—SOFR spread is above average level).

Benchmark longevity and fallbacks

History suggests that benchmarks may come and go: LIBOR is a great example. Will all or any of the alternatives survive until the end of a contract?

Although this may be a risk, the management of that risk is something which should be factored into the use of any benchmark. The simplest way to manage this is to ensure each contract has an effective fallback to be used in case of a benchmark failure.

Summary

There is no right answer for which reference rate to use: it all depends on the person and the use case.

It is clear that there are alternatives to compounded SOFR and these are being used in USD transactions. The extent of their use will continue to develop as users are made aware of them and adopt the most appropriate reference rate for their needs.