The Secured Overnight Financing Rate (SOFR) has emerged as the leading interest rate to replace dollar LIBOR (London Interbank Offered Rate), which is scheduled to phase out by the end of June 2023. Although SOFR is an overnight rate, it has typically been used in compounded and term versions for loans, bonds, and securitizations (references to SOFR in this article mean SOFR-based rates in general).

LIBOR has been used as a leading floating-rate benchmark in an estimated $200 trillion worth of contracts worldwide. Globally, changes have occurred first outside the U.S. and are well underway in the U.S. market as LIBOR cessation starts to come into focus.

In the U.S., the Federal Reserve Bank of New York (the Fed) developed and now publishes SOFR daily since April 2018. Overnight SOFR is calculated as a volume-weighted median of various transaction-level repo data. Until the market gained enough liquidity to develop a forward-looking term rate for SOFR, market participants used one-, three-, six-, and 12-month compounded SOFR. When S&P Global Ratings previously examined LIBOR and SOFR in 2020, we used compounded SOFR to examine the spread differential with respect to the corresponding LIBOR term rates. Since then, term SOFR rates have emerged and are derived from futures contracts; they incorporate a forward-looking view of interest rates.

Federal Law Provides A Path Forward

The Adjustable Interest Rate (LIBOR) Act was signed into law on March 15, 2022. This federal law establishes a process on a nationwide basis for replacing LIBOR in existing contracts that do not specify a clearly defined or practical replacement rate and are difficult to amend (i.e., "tough legacy" contracts). We believe there is a strong incentive to use SOFR because the choice of a SOFR-based rate makes the selecting parties eligible for a legal safe harbor against litigation. Furthermore, the law provides automatic selection of a SOFR-based rate if a replacement rate is not specified by June 30, 2023, in all then-remaining LIBOR contracts.

Also now embedded into law are fixed spread adjustments applied to SOFR replacement rates, which are unchanged from the Alternative Reference Rates Committee (ARRC) recommendations.

Table 1

Term SOFR's Emergence

Up until 2021, compounded SOFR was the primary type of SOFR rate being used as an alternative floating-rate benchmark by borrowers and lenders. As SOFR futures market liquidity developed, a new SOFR forward-looking rate emerged that reflects future market expectations on interest rates (as derived from the derivatives markets). The Chicago Mercantile Exchange (CME) calculates and publishes a daily set of forward looking SOFR interest rates for one-month, three-month, six-month and 12-month tenors. The methodology uses a combination of one-month and three-month SOFR futures. The one-/three-/six-month settings for term SOFR (we refer to CME term SOFR simply as "term SOFR") were endorsed by the ARRC in July 2021. In May 2022, the ARRC also endorsed the 12-month term rate. CME's rates appear to us to be emerging as the benchmark rates of choice in U.S. syndicated lending. Since January 2022, more than $180 billion of leveraged loans were arranged using the term SOFR benchmark rates. Term SOFR rates have also emerged as the benchmark rates of choice for new issuance in some floating-rate sectors of structured finance, such as single-asset single-borrower commercial mortgage-backed securities (SASB CMBS) and collateralized loan obligations (CLOs).

From January through August 2022, the total CLO debt outstanding referencing CME's term SOFR surpassed $38 billion. We believe SOFR-based rates--daily simple, compounded, and term--are likely to coexist for some time in a new multi-rate post-LIBOR rate ecosystem. To date, we have seen that mortgage and student loans are using compounded SOFR in underlying contracts, as do liabilities on some new asset-backed securities transactions. Most recently, unsecured floating-rate bank and government-sponsored enterprise debt have used compounded SOFR. In selecting their choice of SOFR-based rates, market participants may consider operational matters and depth of transactions behind a particular rate selection, among other factors. For new-issue CLOs in 2022, the choice of term SOFR has been driven by the underlying leveraged loan market, which has started using term SOFR. New-issue floating-rate CMBS (SASB) transactions have also started using term SOFR rates. For legacy contracts, term SOFR can be operationalized similarly to LIBOR and thus provides an easier path to smooth transition for many contracts (particularly those securitizations where the underlying assets are also using term SOFR rates).

Rising Interest Rates Reveal Differences Among SOFR Rates

As market expectations for higher future interest rates started building in early 2022, compounded and term SOFR rates started to diverge significantly (see chart 1). This divergence is not a surprise, as term SOFR rates provide a forward-looking view of interest rates, while compounded SOFR reflects a backward-looking view. Some users of compounded SOFR have also narrowed some of this gap by utilizing "in arrears" interest payment mechanics that determine the interest rate toward the end of the interest period and more closely match the rate with the time period being covered. In some cases, such as with the three-month setting, the difference between compounded SOFR and term SOFR has been close to 1.5%. To the extent market interest rate increases moderate, we would expect these differences to narrow, or even reverse if rates are expected to fall.

Chart 1

Table 2 shows the numerical differences between compounded and term SOFR for four dates. The time periods over which the rates are reported are adjacent. The compounded rate ("in advance") is aggregating the view of interest rates over the prior period. Compounded SOFR rates used in arrears are much closer to term SOFR rates than when used in advance. Term SOFR expresses a view for the period starting with the reporting date.

Table 2

Possible Use of Non-SOFR Rates

While the derivatives market has embraced SOFR as the governing replacement rate for dollar LIBOR, the lending market (cash products) has explored different alternative rates, including those that incorporate a credit component, and hence provide a partial hedge in periods of economic stress and rising funding costs. For some lenders, the absence of credit risk in a benchmark rate can potentially create a mismatch between assets and liabilities. It may provide sufficient motivation to seek alternative benchmark rates, and there may be a role for credit-sensitive rates in this area in the longer term. Over the past several years, there have been a number of Credit Sensitivity Group workshops hosted by the Fed, which explored methodologies to develop a robust lending framework that considers a credit-sensitive rate/spread that could be added to the SOFR (see "Transition from LIBOR: Credit Sensitivity Group Workshops," Feb. 4, 2021, on www.newyorkfed.org.)

During recent periods of financial stress, accompanied by monetary easing and a flight to quality investments, LIBOR and SOFR temporarily diverged 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 spreads between LIBOR term rates and their corresponding compounded and term SOFR rates widened to approximately 1%. This gap narrowed significantly, however, after several months (see chart 2).

Chart 2

In the U.S., we have seen the development of at least two credit-sensitive floating rates: Bloomberg's Short-Term Bank Yield Index (BSBY) and American Financial Exchange's Ameribor. Similar to SOFR-based rates, these rates also do not rely on contributions from panel banks or expert judgement like LIBOR, but on actual financial instrument transactions--in these cases, involving commercial paper (CP) and certificates of deposits (CDs). Besides incorporating credit risk, the credit sensitive alternative rates are also forward looking.

Overview of credit-sensitive rates

The BSBY Index seeks to measure the average yields at which large global banks access U.S. dollar senior unsecured marginal wholesale funding. The index is based on transaction-related data and firm executable quotes of CP, CDs, deposits from Bloomberg electronic trading solutions, and the trades of senior unsecured bank corporate bonds as reported in the Trade Reporting and Compliance Engine (TRACE). Certain selection rules and curve-fitting methodologies are included in the calculation of the index for the one-, three-, six-, and 12-month tenors.

The Ameribor Term-30 (AMBOR 30T) and Term-90 (AMBOR 90T) aim to represent 30-day and 90-day funding costs, respectively, for a range of U.S. banks and financial institutions. AMBOR 30T and 90T are calculated using actual transaction data, combining Ameribor unsecured lending data from American Financial Exchange's (AFX) overnight and 30-day markets, alongside CP and commercial deposit issuances from U.S.-based financial institutions provided by the Depository Trust & Clearing Corp. The AFX introduced AMBOR 30T and 90T as alternative benchmarks for one-month and three-month LIBOR, respectively.

Both rates have historical time series data that extend back to approximately 2016. They rely on input data on financial commercial paper and, as a consequence, inherit the risks to which commercial paper is exposed during periods of stress (e.g., spring 2020), such as lack of liquidity. Each of these indices have fall-back calculation provisions that mitigate temporary liquidity stresses when data may be sparse or insufficient for the index calculation.

Table 3 summarizes key takeaways for LIBOR and the risk-free alternative benchmark (SOFR), as well as the credit-sensitive rates.

Table 3

SOFR And Non-SOFR Rates Generally Follow LIBOR Patterns

We have observed a close relationship between forward-looking LIBOR and compounded SOFR, term SOFR, BSBY, and Ameribor over the same period (see chart 3). However, because SOFR does not include the credit risk or term structure characteristics of LIBOR, the former has generally been lower. In periods of elevated credit stress in markets underlying credit-sensitive rates, SOFR rates may diverge from what LIBOR would have been during such periods.

Chart 3

An expanded view of the first eight months of 2022 shows compounded SOFR diverging significantly from term rates when plotting the forward-looking LIBOR rate, term SOFR, BSBY, and Ameribor determined at the beginning of the interest rate period together with the corresponding compounded one-month SOFR rates over the prior time period (see chart 4). When analyzing rates published on a given day, compounded rates and forward-looking term rates refer to different time periods. The term rates incorporate the interest rate expectations for the following interest rate period, while compounded rates reflect the prior time period. For other maturities (three, six, 12 months), with all else being equal, as the tenor increases, the difference between compounded SOFR and term SOFR rates grows.

Chart 4

Historical Spreads Of LIBOR Over SOFR And Non-SOFR Rates

Table 4 provides an overview of the one-month rate differences and correlation figures between dollar LIBOR and compounded SOFR, term SOFR, BSBY, and Ameribor over the available time periods. (For additional insight into the spread differential between dollar LIBOR and the alternative rates, see the appendix.)

Table 4

The newer rates have only been around for a few years, unlike LIBOR and repo data, which have existed for decades across multiple credit cycles. The average of the spread differential between LIBOR and credit-sensitive rates is close to zero. This is because the credit-sensitive rates embed a credit component (similar to LIBOR) and, as such, this explicitly embeds the credit spread adjustment that is absent in SOFR. The high correlation numbers show that despite being at different levels at times, the SOFR-based rates, BSBY, and Ameribor have been tracking closely with dollar LIBOR.

Our spread analysis for the credit-sensitive rates does not address liquidity, volume, or market acceptance of these non-SOFR-based rates. The market for non-SOFR-based rates is still developing.

The analysis for the three-month rates in table 5 shows a similar story. While the average credit spread differential between three-month LIBOR and three-month SOFR is 26 basis points (bps) for compounded SOFR and 21 bps for term SOFR, the credit-sensitive rates exhibit a close to zero average basis with LIBOR. The correlation between LIBOR and the other rates continues to show a close relationship. However, the length of the term SOFR time series data is much shorter than the compounded SOFR data. The table shows statistics based on the actual length of data for the various rates publicly available.

Table 5

Appendix

The appendix presents more detailed information on the spread differential between LIBOR and compounded SOFR, term SOFR, BSBY, and Ameribor. This information provides more insight into how the above rates tracked each other through time and how the spread differential between the rates evolved. The different percentiles show, in addition to average and median, the largest spreads between LIBOR and the alternative rates over the available historical data.

Table 6

Table 7

Related Research

• U.K. RMBS And ABS LIBOR Transition: Beware of Early Success, Sept. 5, (2022
• Scenario Analysis: LIBOR Transition, Excess Spread, And U.S. CLO Ratings, June 30, 2022
• Beyond The Term Sheet: Analysis of LIBOR Transition Language Within Executed Credit Agreements, Feb. 10, 2022
• Failure To Replace Discontinued LIBOR Settings Could Lead To Issue Credit Rating Actions, Nov. 15, 2021
• European And Japanese Structured Finance Markets Approach LIBOR Cessation While U.S. Markets Prepare For A Major Shift, Nov. 2, 2021
• LIBOR Transition: Laws Won't Eliminate All Uncertainty, May 14, 2021
• SOFR Emerging As Alternative to LIBOR In U.S. Debt Markets, Dec. 4, 2020