articles Ratings /ratings/en/research/articles/201204-sofr-emerging-as-alternative-to-libor-in-u-s-debt-markets-11752050 content esgSubNav
Log in to other products

 /


Looking for more?

In This List
COMMENTS

SOFR Emerging As Alternative To LIBOR In U.S. Debt Markets

COMMENTS

Property In Transition: Zooming In On The Global Office Reboot

COMMENTS

CLO Spotlight: CDO Monitor Benchmarks Report For U.S. CLOs: First-Quarter 2021

COMMENTS

Tech Disruption In Retail Banking: CEE Banks Are On The Digital Fast Lane

COMMENTS

COVID-19 Impact: Key Takeaways From Our Articles


SOFR Emerging As Alternative To LIBOR In U.S. Debt Markets

Following the July 2017 announcement by the U.K.'s Financial Conduct Authority that the London Interbank Offered Rate (LIBOR) cannot be assured following 2021, there has been significant discussion around replacement benchmark rates in financial markets. A recent consultation published by the ICE Benchmark Administrator and supported by the U.S. Federal Reserve has proposed to continue dollar LIBOR quotes for the most actively used maturities on legacy transactions until June 2023. Furthermore, U.S. bank regulatory agencies have recently stated that banks should stop using dollar LIBOR in new contracts "as soon as practicable" and, in any event, by Dec. 31, 2021. For U.S. debt instruments (including structured finance securities) with dollar LIBOR exposures and maturities beyond 2023, this will mean changes to benchmark interest rates. While market participants are working to build provisions for alternative benchmarks in new transactions, one source of continued uncertainty centers around legacy transactions where fallback language varies widely.

In the U.S. the Federal Reserve Bank of New York ("the Fed") has developed, and is now publishing on a daily basis, the Secured Overnight Financing Rate (SOFR). Although there are a number of differences with LIBOR, this near-risk-free rate has been viewed by many as the leading replacement rate in U.S. financial markets for dollar LIBOR, similar to how the Sterling Overnight Index Average Rate (SONIA) has been a replacement rate for Sterling LIBOR in the U.K. While SOFR has been published since April 2018, the Fed has released a longer time series, from August 2014 to March 2018, with modeled pre-production estimated data on SOFR that now underlie the official rate publication. Outside the U.S., central banks and financial market authorities have also been charting courses toward new replacement benchmarks set to become active by 2021.

The Transition Away From LIBOR May Entail Basis Risk

For U.S. markets, the eventual phase-out of LIBOR has led to a robust discussion of basis risk between LIBOR term indices and SOFR. Given the rise of SOFR and related derivative contracts, we have examined in more detail its characteristics and history from 2018, as well as its relationship to similar rates over a longer time horizon. This analysis has helped us better consider different types of potential basis risk relevant to debt facilities and transactions with LIBOR exposures. For structured finance markets, the transition of assets and liabilities to a SOFR basis from a LIBOR basis may not happen simultaneously. For example, some recent structured finance transactions that incorporate Alternative Reference Rates Committee fallbacks for liabilities may switch to SOFR rates if over 50% of the underlying assets have switched away from LIBOR rates.

Key Differences Between SOFR And LIBOR

LIBOR is an unsecured rate among banks that includes the credit risk of the borrowing banks embedded in the rates with various maturities (one month, three months, six months, 12 months, etc.). SOFR is a secured overnight borrowing rate collateralized by Treasury securities that is nearly risk free (the potential residual risk is the market risk associated with the collateral; this is addressed through overcollateralization as in a typical repurchase agreement). Accordingly, a spread would need to be added to SOFR in order to approximate a prior LIBOR rate to preserve transaction economics and minimize any value transfer between borrower and lender. The offset won't be perfect because the spread is likely to be a static percentage, while the differential between LIBOR and SOFR is dynamic through time. Although time is drawing near for issuers to develop and execute their plans for LIBOR transition, over the longer term we believe there will be significant market interest in dynamic credit adjustments to be used with risk-free rates.

To overcome some of the shortfalls of LIBOR, SOFR is designed around actual transactions (overnight lending collateralized by Treasurys) rather than a survey of bank rates combined with bank oversight and judgment. Given the sheer size of transactions determining SOFR (approximately $1 trillion/day), it appears more representative than the much smaller daily volumes supporting LIBOR (averaging about $500 million) when taking into account the large exposures referencing dollar LIBOR.

Because LIBOR has forward rates and SOFR does not yet have forward rates, there are also changes in how interest rate calculations would be determined. As is currently the case with SOFR, the daily rate can be compounded for periods such as one or three months and is published by the Fed. Some issuers are incorporating detailed fallback language into their contracts such that they would switch to compounded daily SOFR from LIBOR, and then switch again to term SOFR if it became available. We will continue to monitor developments in this area.

SOFR historical comparison to LIBOR

We undertook an analysis of one-, three-, six-, and 12-month compounded in arrears SOFR to examine the spread differential with respect to the corresponding LIBOR term rates as the market starts its shift away from LIBOR. The SOFR one-month, three-month, six-month, and 12-month rates in this analysis are compounded daily using the SOFR overnight rate.

Even though the U.S. Federal Reserve backfilled the time series for SOFR to August 2014, the amount of data from 2014 to 2020 remains relatively short for meaningful statistical analysis. More importantly, it excludes the stressful 2008 financial crisis period. To mitigate the limited data, we used the Effective Fed Funds Rate Overnight Index Swap (EFFR OIS) index and the U.S. Treasuries Overnight Repurchase Agreement index from data provider IHS Global Insight as proxies for SOFR. Historically, these indices and the SOFR rate have moved closely with each other (see chart 1).

Chart 1

image

Close relationship between backward-looking SOFR and forward-looking LIBOR

There has been a close relationship between backward-looking compounded SOFR and forward-looking LIBOR determined for the same period. However, since SOFR does not include the credit risk or term structure characteristics of LIBOR, the former has generally been lower. In chart 2, we have plotted the compounded backward-looking one-month SOFR rates at the end of the interest period and the corresponding forward-looking LIBOR rate determined at the beginning of the same period.

Chart 2

image

Analysis of historical spreads of LIBOR over SOFR

To switch to SOFR from LIBOR-based interest rates, market participants typically add a spread to risk-free SOFR. Table 1 provides an overview of the rate differences between SOFR and one-, three-, six-, and 12-month LIBOR since 2014. The rate differential between SOFR and LIBOR becomes larger the longer the tenor. This is logical, as it reflects the general increase in credit risk when exposed over longer time horizons. (For additional insight into the SOFR to dollar LIBOR spread differential, see table 2 in the appendix. Tables 3 and 4 in the appendix summarize the spreads between LIBOR and EFFR and Global Insight repo index.)

Table 1

Spread Of LIBOR Over Compounded Daily SOFR
(August 2014–October 2020)
One-month LIBOR (%) Three-month LIBOR (%) Six-month LIBOR (%) 12-month LIBOR (%)
Mean 0.12 0.30 0.45 0.63
Median 0.09 0.25 0.37 0.57
Source: Bloomberg, S&P Global Ratings.

Historical Analysis Of The September 2019 Spike In U.S. Repo Rates

While not representative of generalized bank sector stress, such as in 2008, during the week of Sept. 16, 2019, the daily SOFR, a volume-weighted median for general collateral repo trades, rose as high as 5.25% (see chart 3). Some repo transactions priced as high as 9.00%. The mid-September jump shows that the daily SOFR can demonstrate volatility and spike higher than LIBOR. However, since that September event, the Fed added significant term repo capacity, together with other liquidity measures, to prevent such a situation from recurring.

Chart 3

image

The compounding conventions used for one-month and three-month SOFR time periods (mirroring LIBOR maturities) significantly mitigate and smooth out most of the volatility in this new benchmark. For example, the Sept. 17, 2019, jump to 5.25% in the SOFR overnight rate would only result in an approximately 15-basis-point increase in the SOFR one-month rate and a five-basis-point increase in the SOFR three-month rate. Nonetheless, market participants have expressed concern over this volatility.

During periods of financial stress accompanied by monetary easing and a flight to quality investment flows, LIBOR and SOFR temporarily diverge given the differences in credit risk exposure contained in these benchmark rates. In spring 2020, when COVID caused economic weakness, LIBOR and SOFR trended in opposite directions for a short period of time as authorities quickly and sharply cut policy interest rates. The spread between the LIBOR one-month and SOFR overnight widened to approximately 1%, which is much higher than the historical average. The spreads between LIBOR term rates and their corresponding compounded backward-looking SOFR term rates were even larger. This gap narrowed significantly, however, after several months (see chart 4). Similar behavior occurred during the global financial crisis in 2008, when the spread differential between LIBOR and EFFR index/IHS Global Insight U.S. Treasuries Overnight Repurchase Agreement index widened to an even larger degree.

Chart 4

image

Appendix

Table 2 shows more information on the distribution of the basis between LIBOR and SOFR since 2014.

Table 2

Spread Of LIBOR Over SOFR--Detailed
2014-2020
Spread 2014-2020 (%)
Percentile LIBOR1M - SOFR1M LIBOR3M - SOFR3M LIBOR6M - SOFR6M LIBOR12M - SOFR12M
Max 1.00 1.40 1.45 1.37
95% 0.25 0.68 1.05 1.02
90% 0.22 0.49 0.78 0.88
85% 0.19 0.44 0.68 0.83
80% 0.18 0.40 0.60 0.81
Median 0.09 0.25 0.37 0.57
Average 0.12 0.30 0.45 0.63
SOFR--Secured Overnight Financing Rate. LIBOR--London Interbank Offered Rate.

Tables 3 and 4 below show the mean and median difference between term LIBOR rates and the EFFR and Global Insight repo indices.

Table 3

Spread Of LIBOR Over EFFR
January 2002–October 2020
One-month LIBOR (%) Three-month LIBOR (%)
Mean 0.15 0.26
Median 0.09 0.15
Source: Bloomberg, S&P Global Ratings. LIBOR--London Interbank Offered Rate. EFFR--Effective Fed Funds Rate.

Table 4

Spread Of LIBOR Over Global Insight Repo
January 1997–October 2020
One-month LIBOR (%) Three-month LIBOR (%) Six-month LIBOR (%) 12-month LIBOR (%)
Mean 0.16 0.3 0.44 0.68
Median 0.1 0.18 0.31 0.6
Source: IHS Global Insight, Bloomberg, S&P Global Ratings. LIBOR--London Interbank Offered Rate.

Related Criteria

Related Research

This report does not constitute a rating action.

Contacts:Cristina Polizu, PhD, New York + 1 (212) 438 2576;
cristina.polizu@spglobal.com
Derek Ding, New York + 1 (212) 438 3563;
derek.ding@spglobal.com
John A Detweiler, CFA, New York + 1 (212) 438 7319;
john.detweiler@spglobal.com
Geoffrey E Buswick, Boston + 1 (617) 530 8311;
geoffrey.buswick@spglobal.com
Stuart Plesser, New York + 1 (212) 438 6870;
stuart.plesser@spglobal.com
Nik Khakee, New York + 1 (212) 438 2473;
nik.khakee@spglobal.com
Ramki Muthukrishnan, New York + 1 (212) 438 1384;
ramki.muthukrishnan@spglobal.com
David N Bodek, New York + 1 (212) 438 7969;
david.bodek@spglobal.com

No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.

Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.

To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.

S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.

S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact S&P Global Ratings, Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-7280 or by e-mail to: research_request@spglobal.com.


Register with S&P Global Ratings

Register now to access exclusive content, events, tools, and more.

Go Back