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Article

SOFR monthly transaction activity — August 2020

Date:
August 24, 2020

Summary

Each month, our team discusses the current state of USD LIBOR and SOFR markets, exploring both the performance of the rates as well as the borrowing and hedging markets that surround them.

Since the U.K. Financial Conduct Authority’s 2017 announcement that LIBOR would not be supported beyond 2021, market participants have been progressing towards the adoption replacement indices. This process has moved slowly to date, but with critical deadlines approaching over the next 18 months, U.S. market participants can expect for SOFR-based transactions to become more prevalent.

This update addresses the current state of USD LIBOR and SOFR markets, exploring both performance of the rates and the borrowing and hedging markets that surround them.

Highlights

  • The spot spread between LIBOR and SOFR has averaged around 13 bps since the end of May, as compared to recent months in which they diverged by as much as 97 bps due to the credit component of USD LIBOR.
  • The five-year historical median spread between LIBOR and SOFR, identified as the preferred spread adjustment methodology in the transition from LIBOR to SOFR, has risen to 11-12 bps on 1-month tenor and 26–27 bps on 3-month tenor, largely on account of the recent divergence between the indices.
  • Some expect transaction volume and count to pick up as Freddie Mac and Fannie Mae transition from LIBOR to SOFR as the index underlying ARMs and SARMs.
  • As of the date of this publication, we have not yet seen a SOFR-based OTC hedge transaction. Some expect activity to commence in Q4 2020, when the Agencies may begin to close on SOFR-based loans.

Performance of USD LIBOR and SOFR

Compounded SOFR vs USD LIBOR over the last 12 months

Figure 1. The spread between 1-month LIBOR and SOFR compounded in arrears reflects the spot difference between the rates, as opposed to the historical five-year median spread adjustment on that date. Source: Chatham Models and Historical Benchmark Data

  • USD LIBOR and SOFR compounded in arrears, the primary backward-looking calculation methodology recommended by the ARRC and ISDA (unless otherwise indicated, all subsequent references to SOFR will mean SOFR compounded in arrears), tend to be highly correlated and directionally aligned.
  • The spot spread between LIBOR and SOFR has averaged around 13 bps since the end of May, as compared to March and April in which they diverged by as much as 97 bps due to the credit component of USD LIBOR. For more information re the relative performance of LIBOR and SOFR earlier in 2020, see Chatham’s market update - May 11, 2020.

USD LIBOR to SOFR spread adjustment

Five year historical median spread between LIBOR and SOFR compounded in arrears

Figure 2. Spread adjustment between LIBOR and SOFR compounded in arrears for 1-month and 3-month tenors. Source: Chatham using historical benchmark data

  • Transitioning a USD LIBOR-based loan or hedge to a SOFR-based instrument necessitates adjusting the loan/hedge spread to keep the parties economically indifferent.
  • The ARRC Consultation on Spread Adjustment Methodologies for Fallbacks in Cash Products Referencing USD LIBOR, recommended a spread adjustment calculated as the median difference between USD LIBOR and SOFR over a five-year lookback period prior to the fallback date.
  • The five-year historical median spread has increased by about 0.6 bps on 3-month tenor and about 0.3 bps on 1-month tenor since June, largely on account of the recent divergence between the indices.

Hedging activity in USD LIBOR and SOFR markets

USD LIBOR and SOFR Transaction Data

Figure 3. Transaction volume and count comparison of USD LIBOR and SOFR based derivatives. Source: ISDA SwapsInfo

  • As of today, LIBOR continues to be the primary index hedged in the market, with SOFR orders of magnitude behind in both transaction volume and count.
  • Some expect transaction volume and count to pick up as Freddie Mac and Fannie Mae transition from LIBOR to SOFR as the index underlying ARMs and SARMs. For more information about this transition, please see Chatham’s most recent FAQ: USD LIBOR Transition to SOFR.
SOFR Transaction Count by Tenor

Figure 4. SOFR derivative transaction volume by tenor. Source: ISDA SwapsInfo

  • As of the date of this publication, we have not yet seen a SOFR-based OTC hedge transaction.
  • Some expect activity to commence in Q4 2020, when the Agencies may begin to close on SOFR-based loans.
  • This expectation may be tempered by the fact that Freddie Mac will allow LIBOR-based caps on SOFR-based loans for an as yet undetermined period of time, and that Fannie Mae will offer a SOFR-based product with an embedded interest rate cap.
SOFR Transaction Volume by Tenor (USD billions)

Figure 5. Transaction volume represents notional hedged (USD billions) for new SOFR-indexed derivatives. Source: ISDA SwapsInfo

  • Despite the more heterogeneous spread among SOFR transaction counts by tenor, most of the transaction volume is done in trades up to one year, predominantly in the overnight markets.
  • There is some growth in trades between 1-year and 5-years, most likely due to an increase in basis swaps.

Speak to a Chatham expert

Please reach out to the Chatham team if you have questions around the USD LIBOR transition or how the use of SOFR in your loans and derivatives could impact your interest rate exposure.

Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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