As many of our readers already know, SOFR (Secured Overnight Financing Rate) has been selected by the Alternative Reference Rates Committee of the Federal Reserve to replace LIBOR in 2021.
LIBOR represents the rate member banks borrow from each other, while SOFR represents a “secured” interest rate index, meaning it has no credit risk component. The most common use for LIBOR in hedge accounting is a 1- or 3-month rate, and SOFR is priced as an overnight interest rate index.
In this blog, we review how the SOFR index has reacted in the credit markets during times of stress, some of the characteristics of the benchmark, the likelihood of SOFR to replace LIBOR and how hedge accounting may be impacted by rate reform.
Challenges of SOFR
#1. Pricing in Crisis
LIBOR is — was — not a very good index. This is because the price was determined by polling, not actual transactions.
However, it still had some merit because as liquidity tightened, LIBOR rates increased, and when credit markets relaxed, so did LIBOR. This pricing mechanism was useful in the marketplace because it reflected (or nearly reflected) the cost of funds on a credit adjusted basis.
SOFR is completely different since it is secured by treasuries (collateral). During a crisis, the flight to quality actually reduces the SOFR interest rate—exactly when rates should be rising.
In September 2019, the SOFR interest rate surged because of liquidity concerns. Demand for excess reserves increased at a time when reserves were in short supply, causing the SOFR rate to spike up to nearly 6 percent when 1-month LIBOR was near 2 percent. So, in times of credit crisis, SOFR may get priced too low, and at other times, when treasuries increase too quickly, it can spike in the overnight market. While these peaks and valleys show volatility in the index, it is also true that the daily rate is averaged and the peaks and valleys were brief.
#2. Creating a Credit Adjusted Lending Rate
Another challenge for the SOFR rate is knowing how to add an appropriate spread to create a credit adjusted lending rate. In times of low volatility, the credit adjusted lending rate might not be too hard to derive. But what happens when the markets are shocked by current events such as oil at -$37 a barrel, Fed Funds at 0%, or a pandemic that reduces lending to only the most creditworthy borrowers? A static credit spread won’t do the trick, and some banks don’t believe a dynamic credit spread approach will work any better over time.
A Case For Alternative Indexes
Some argue that we could see several new “indexes” becoming more relevant to the credit markets. Indexes such as AMERIBOR are like an unsecured version of SOFR and provides information about the cost of funds for unsecured overnight lending. Rates like these may more closely reflect the true cost of borrowing in the real world. Some lenders want AMERIBOR and other indexes to be added as benchmark reference rates by the FASB.
SOFR: The Likely Reality
The reality is that SOFR has a very high probability of becoming the next benchmark interest rate, replacing LIBOR as the most quoted and used index in the credit market. That means the recent market dips and spikes that have already occurred in SOFR will need to be worked out—and they will be. As more and more participants begin to use the new reference rate, the market for this product will grow, mature and even the credit spread conundrum is expected to be worked out over time.
Hedge Accounting Impacts
Benchmark interest rates limit the ability of hedgers to hedge certain interest rate risk and apply hedge accounting. Cash flow hedgers won’t be impacted as severely by reference rate reform as fair value hedgers because as long as the cash flow hedge relationship demonstrates a highly effective relationship, a cash flow hedge can hedge any contractual interest rate.
It’s different for those looking to apply fair value hedge accounting. Fair value hedgers must adjust the hedged item based on changes to the risk being hedged, and the most favorable results use a benchmark interest rate. That means the benchmark choice matters a lot.
At this time, SOFR looks likely to replace LIBOR as the new reference rate. And while the current SOFR market lacks a long- dated yield curve, credit component and market volume, it is supported by the Federal Reserve as the new benchmark reference rate.
The market still has time to work out some of the recent kinks before 2021, and lessons learned from the current COVID-19 and oil price-related shocks should help develop some needed maturity in this market.
At Hedge Tackers, we are following this change as it unfolds so that interest rate risk hedgers can successfully navigate the end of LIBOR.
If you need any help organizing your LIBOR transition, contact our team.