Rival SOFR conventions splinter loan market

Diverging approaches to calculating interest payments sow uncertainty and hedging concerns

Nature, as Aristotle observed, abhors a vacuum. So, it seems, do fixed income markets.

In the absence of an official forward-looking term version of SOFR, the secured overnight financing rate, various segments of the market have developed their own conventions for calculating interest payments based on US dollar Libor’s chosen successor.

“You can’t pin a multi-trillion dollar business on the hope that there will be a forward-looking term SOFR,” says Meredith Coffey, executive vice-president of research and public policy at the Loan Syndications and Trading Association. “The work on new conventions must therefore be done.”

The problem is that different parts of the market are taking different paths, resulting in a plethora of contrasting conventions for calculating backward-looking SOFR term rates. Syndicated loans will use a so-called daily simple rate. Swaps and floating rates notes (FRNs) will compound the daily SOFR rate over the current interest period, with a lag to allow time to arrange payment. The mortgage market has opted for SOFR compounding-in-advance, ahead of the current interest period. A convention for bilateral loans is still being worked out.

This splintering could cause new headaches for the market. The use of multiple conventions across contracts that previously referenced the same Libor rates will give rise to new basis risks, which must be carefully managed when hedging. “It’s a legitimate and real concern,” says David Knutson, head of credit research at Schroders. “Hedging inefficiencies are just air pockets, so they can create problems, but if a good pilot understands them and can anticipate them, then they can be managed.”

Hanging over all of this is a deep longing in many parts of the market for a forward-looking term SOFR rate. “There’s a view that it would be great to have a forward curve now,” says Kristi Leo, president of the Structured Finance Association. “We’ve mentioned it many times in our responses to regulators in requests for comments. We certainly would love to have it.”

The market may not have to wait much longer. The Alternative Reference Rates Committee (ARRC) tasked with co-ordinating the transition away from Libor will begin reviewing term SOFR proposals in September, with publication slated to begin in the first half of 2021. Some benchmark administrators are optimistic a term SOFR rate could be ready by the end of this year, at least in trial form.

But that timeline is conditional on there being sufficient liquidity in SOFR-linked derivatives to construct a forward curve – a far from guaranteed proposition, given SOFR swap volumes are currently less than 1% of Libor equivalents.

In the meantime, the US Treasury is looking at issuing FRNs linked to SOFR – a move that could unite the market around a single convention for calculating backward-looking rates, and push term SOFR to the sidelines.  

Competing conventions

To date, usage of SOFR in cash products has been limited. According to the ARRC, there was $680 billion of floating rate SOFR debt outstanding as of August 2020, compared with trillions referencing US dollar Libor.

The emergence of accepted conventions for calculating interest payments linked to SOFR could spur more issuance, but it will also bring new complications.

The derivatives market was quick to embrace compounding in-arrears, where a term rate is calculated at the end of the interest period by looking backwards and compounding the daily overnight rates. The cash market was expected to follow suit. Instead, it started splintering.

FRNs went for compounding. Initially, the syndicated loan market – which has an estimated $1.5 trillion of exposure to US dollar Libor – seemed poised to adopt the same convention. But an industry consultation revealed a preference for a daily simple convention, where the outstanding balance of a loan is multiplied by the overnight SOFR rate on a daily basis. This differs from compounding in-arrears and simple averaging, where the average daily rate is applied to the principal at the end of the interest period. The advantage of the daily simple convention is that it allows for the prepayment of loans.      

A consumer mortgage cannot be treated as a utility bill where you find out at the end of the month what the interest payment you owed was

Ameez Nanjee, Freddie Mac

“Many of the conventions that are used in securities markets are not applicable in the loan market,” says Coffey, who chairs the ARRC’s working group on business loans. “Loans have characteristics such as prepayments. And because they can prepay at any time, applying an average rate at the end of a period to a fixed principal doesn’t work.”

After considering the feedback from the market, the working group recommended the daily simple SOFR as the primary convention for syndicated loans, with compounding-in-arrears as a secondary option for those that prefer to use it.

 

 

The mortgage market is moving in yet another direction. To be eligible for purchase by Fannie Mae and Freddie Mac, adjustable rate mortgages must use SOFR compounded-in-advance, where interest payments are calculated based using overnight rates from the prior month or quarter. For instance, monthly interest payments for August would be based on daily rates in July. 

One of the reasons for opting for this convention is to satisfy the “qualified mortgage” rule, which states that consumers must be informed of their interest rate 45 days in advance.

“A consumer mortgage cannot be treated as a utility bill where you find out at the end of the month what the interest payment you owed was,” says Ameez Nanjee, vice-president for asset and liability management in the investments and capital markets division at Freddie Mac.

Basis risk

The differing conventions could introduce basis risks across products that were previously aligned. According to an ARRC report, compounding-in-arrears “more accurately reflects the time value of money” and products that use this convention “will have less hedging basis”. The extent of that basis varies. The difference between daily simple and compounded SOFR has been almost non-existent since 2008, though it can be meaningful when interest rates are elevated. Research from the ARRC shows the basis was as high as 11 basis points for a six-month reset in the early 2000s.

Compounding-in-advance can result in a much higher basis versus contracts that use a compounded-in-arrears convention. ARRC research shows that while the difference has amounted to a few basis points since 2008, it was as high as negative 50bp for a six-month reset just prior to the financial crisis. 

A fleeting basis will also emerge immediately following changes to policy rates. If the Fed lowers or raises interest rates, the change would be reflected in the compounded-in-arrears rate immediately, while the in-advance rate will lag by a month or more. This means mortgage hedges will not perfectly align all the time, though any differences will generally net out over the life of a contract.

For lenders, there’s going to be a basis issue somewhere. I think the market will resolve it with some kind of hedging structure

Sairah Burki, Commercial Real Estate Finance Council

“The only difference will be the timing of those cashflows,” says Nanjee at Freddie Mac. “The cashflows themselves will be the same. So, yes, the in-advance rate will lag in that situation, so ultimately it comes down to the discounting cost of one month of a lag payment.”

Technical differences in the way backward-looking term rates are calculated could create further basis issues, even for contracts that use the same basic conventions. SOFR swaps use compounding-in-arrears with a two-day delay, meaning payment is not due until two days after the end of the interest period. Cash products use a variety of different methods to facilitate time for payments, including lookbacks and observation period shifts, which are bespoke to each contract and track the interest period differently.

Ann Battle, assistant general counsel at the International Swaps and Derivatives Association, says dealers will adapt and offer bespoke swaps to cope with any basis issues that arise. “The OTC derivatives market developed to enable hedging on a bespoke basis. So, I expect we’ll see people come up with different strategies,” she says. That could be easier said than done. Any changes to standard swaps contracts would be incorporated in the International Swaps and Derivatives Association definitions, and also approved by central counterparties in order to be eligible for clearing.   

Sairah Burki, managing director of regulatory policy at the Commercial Real Estate Finance Council, is also confident basis risks can be managed. “For lenders, there’s going to be a basis issue somewhere,” she says, adding: “I think the market will resolve it with some kind of hedging structure.”

The loan market has largely avoided basis issues between cash products and related securitisations. Collateralised loan obligations and residential and commercial mortgage-backed securities are using the same conventions as their respective underlyings. 

The choice of conventions also reflects other considerations, beyond the desire to avoid basis risks. Commercial mortgage-backed securities, for example, will line up with commercial mortgages by using a compounded-in-advance rate. While this may introduce some basis risks when hedging with swaps, any such problems between cash products and securitisations will be minimised. And it should make it easier for the entire commercial real estate market to move to a SOFR term rate when it becomes available.    

“It will be easier to switch from compounding in advance to a term rate precisely because it’s a similar kind of approach,” says Burki.

Looking forward

The yearning for a SOFR term rate is palpable in other segments of the market, too. Freddie Mac has signalled it will use term SOFR, should it become available, for securitisations of multi-family mortgages. It is unknown if it would do the same for other products.

Even FRNs, which have made a smooth transition to SOFR compounded-in-arrears, would still opt for term SOFR if was available, says Schroders’ Knutson.

But the shift to a term SOFR rate is not necessarily inevitable. The market could yet settle on a single convention for backward-looking rates, especially if the US government starts issuing floating rate linked SOFR, with interest payments compounded-in-arrears. The Treasury Department issued a proposal and request for comment in May on the potential issuance of a Treasury FRN indexed to SOFR.

“It will be an orienting North Star for the market to coalesce around,” says Knutson, of the Treasury’s proposed SOFR FRN issuance. “Right now, everyone is just wandering in the wilderness. But if the Treasury comes out and starts issuing SOFR securities, that will be a bright light, like a beacon. And that will help everyone from some municipality in Kansas to JP Morgan march in the same direction.”

A survey conducted earlier this year by the Credit Roundtable, a bond advocacy group, found 85% of respondents would purchase compounded SOFR FRNs if they were issued by the Treasury.

If the Treasury begins issuing SOFR FRNs before a forward-looking term rate becomes available, the rest of the market may well follow its lead. “While forward-looking term rates don’t exist, that would have been seemingly everyone’s preference,” says Christine Scaffidi, senior principal product manager for corporate and syndicated lending at Finastra. “However, we will likely end up with a certain segment of the market that does get comfortable with the complexity of the compounded rate in-arrears, and if they get comfortable with that, even if forward-looking term rates come into play, they may decide to stick with the compounded rate in-arrears,” she adds.

As Aristotle also said, nature does nothing in vain. Perhaps the same is also true of markets.