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

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

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

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

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

Appendix

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

Table 2

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

Related Criteria

• Methodology To Derive Stressed Interest Rates In Structured Finance, Oct. 18, 2019

Related Research

• As The Deadline For The Transition From LIBOR Approaches, Work Remains for U.S. Structured Finance, Oct. 6, 2020
• Losing LIBOR: Most European Banks Are Unlikely To Face a Cliff Edge, Sept. 29, 2020
• Will the Expiration of LIBOR Affect The Credit Quality of U.S. Public Finance Issuers?, Feb. 26, 2020
• The Spike In U.S. Repo Rates Reflects Technical, A Smaller Fed Balance Sheet, And Tighter Bank Regulation, Oct. 2, 2019
• Credit FAQ: How to Say Goodbye to LIBOR Without Creating Market Chaos, Sept/ 23, 2019
• Credit FAQ: SONIA As An Alternative to LIBOR In U.K. Structured Finance Transactions, Feb. 6, 2019