Investors cheer debut Fannie SOFR note launch

Healthy demand could have been higher if S&P had approved benchmark


Buy-side firms have welcomed the first floating rate note (FRN) benchmarked to the Secured Overnight Financing Rate (SOFR), issued by Fannie Mae on July 26, with demand exceeding supply for the product.

The $6 billion issuance, which was underwritten by Barclays, Nomura and TD Securities, is viewed as another crucial step to encouraging broader adoption of the fledgling rate, which was launched in April as a replacement for US dollar Libor.

“The issuance by Fannie Mae represents an important milestone in the evolution and eventual widespread adaptation to SOFR by investors. We view the issuance of floating rate instruments linked to SOFR as critical to its long-term acceptance as a benchmark by all market participants,” says Jerome Schneider, head of short-term portfolio management and funding at Pimco.

The US Federal Reserve, sponsor of the Alternative Reference Rates Committee (ARRC), the industry-led group tasked with promoting a suitable replacement for Libor, sees the first-of-its-kind issuance as proof that SOFR can be used across the market.

“We are seeing more evidence that SOFR can work for a wide range of products, offering a real alternative to Libor not only for derivatives, but for cash products as well,” says David Bowman, senior adviser to the Federal Reserve Board.

The launch follows the European Investment Bank’s Sonia-linked FRN issuance in June, which paid a backward-looking compound average of the Sterling Overnight Index Average.

While bankers say investor demand for the Fannie Mae FRNs exceeded expectations and was more than the $6 billion offered in this issuance, it could have been even greater if more-typical buyers of this product – money market funds (MMFs) – had been able to get involved.

Those funds rated by Standard & Poor’s were unable to purchase the notes as SOFR has not yet been approved by the rating agency as an eligible benchmark for financial products, say market participants. Despite a good majority of funds being rated by S&P, others were able to buy the notes.

“There was a category of investors that could not participate and they’re certainly a class of investors that would be big Fed funds FRN buyers. We would expect that to be resolved, resulting in increased demand,” says Greg Moore, head of fixed income, currencies and metals in the US and head of global commodities at TD Securities.

S&P did not respond to a request for comment. (Update, July 30: after this story was published, S&P announced it had approved SOFR. A follow-up article can be found here).

We are seeing more evidence that SOFR can work for a wide range of products, offering a real alternative to Libor not only for derivatives, but for cash products as well
David Bowman, Federal Reserve Board

The Fannie Mae issuance means that 87% of its FRNs are now linked to SOFR, and participants expect other government agencies to follow suit. Roughly $700 billion of FRNs issued by those entities are currently benchmarked to Libor.

Investors have already been used to buying Fannie Mae FRNs linked to the overnight Fed funds rate. While these notes represent a minority of the market, participants say they still attract demand.

One of the biggest headaches facing the ARRC and regulators pushing for alternative rates is formulating a term rate to help ease the transition for certain market participants. Investors buying one-month or three-month Libor-linked FRNs know their coupon payment in advance, whereas this new issuance is calculated on a daily average of SOFR over the quarter, with a four-day lock-out period at the end in order for money to move from the issuer, through the custodian and paying agent to the investor.

However, the cheapness of the FRNs compared with other related repo products was a draw for some.

The three tranches – of six months, 12 months and 18 months – provided enhanced yield above SOFR of eight, 12, and 16 basis points, respectively.

“A component of SOFR is derived from tri-party repo rates, which is a core investment for our portfolios,” says Susan Hill, a senior portfolio manager at Federated Investors. “A SOFR-based floater at a spread that’s positive relative to portfolios investing in tri-party repo [means] there is a clear pick-up on a daily basis compared to repo.”

The impact of the SOFR notes on MMFs’ weighted average maturity also attracted some funds. MMF portfolios in the US are restricted to a 60-day weighted average maturity, and the Fannie Mae notes affected the calculation by only one day.

“For a lot of the investor base, investing in a SOFR-indexed floater is a good alternative to their overnight repo trades. For the MMF community, which was an active investor class in this deal, these daily resetting floaters only have a one-day impact to their weighted-average-maturity calculations, which is very advantageous for them,” says Michael Hastings, a front-end interest rate trader at Nomura.

Editing by Lukas Becker

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