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Article

SOFR monthly transaction activity — September 2020

Date:
October 5, 2020

Summary

Each month, our team reviews and discusses the current state of USD LIBOR and SOFR markets, exploring the performance of each index as well as the borrowing and derivatives markets around them.

Since the U.K. Financial Conduct Authority’s 2017 announcement that it would not support LIBOR beyond 2021, market participants have been progressing towards the adoption of 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 for September averaged 6.8 bps and maintained a high level of correlation showing stability between the two indexes in the current environment.
  • The relevant spread in the transition to SOFR (five-year historical median spread between LIBOR and SOFR) has increased by about 0.2 bps on 3-month tenors and stayed relatively flat through September with the divergence on 3-month tenors still attributed to credit market impacts in Q2.
  • SOFR transaction volume increased by nearly 400% quarter-over-quarter, with a disproportionate relative increase in longer-tenor transactions in Q3 2020 (a 700% increase in transactions beyond five years, as compared with a 350% increase in transactions in the 1–5-year range).
  • Longer-tenor SOFR transactions increased significantly in September relative to the total number of transactions and transaction volume, despite both totals decreasing in aggregate compared to previous months.
  • September also saw the first SOFR-based OTC hedge transactions on Agency-originated 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 ISDA (unless otherwise indicated, all subsequent references to SOFR will mean SOFR compounded in arrears), tend to be highly correlated and directionally aligned.
  • LIBOR and SOFR maintained a consistent relationship throughout September averaging about 7 bps in difference.

USD LIBOR to SOFR spread adjustment

USD LIBOR to SOFR spread adjustment

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 3-month tenor still arises from the divergence between 3-month LIBOR and 3-month SOFR from March and April of this year (see Chatham’s market update - May 11, 2020).

Hedging activity in USD LIBOR and SOFR markets

USD LIBOR and SOFR transaction data for CY2020

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 continue their transition from LIBOR to SOFR as the index underlying ARMs and SARMs. For more information about this transition, please see Chatham’s FAQ: USD LIBOR Transition to SOFR.

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

  • In September, Chatham executed the first Agency SOFR-based OTC hedge transaction in the market.
  • The number of transactions is likely to increase as the Agencies now only quote SOFR in their floating-rate term sheets.
  • There was a significant increase in total SOFR transactions from the previous quarter, roughly 400%.
  • Similarly, there was a disproportionate increase in longer-tenor transactions in Q3 2020 with a 350% increase in transactions in the 1–5-year range and a sevenfold increase in transactions above five years.
SOFR transaction volume by tenor

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

  • Total SOFR transactions by volume remained relatively consistent from Q2 to Q3 2020, however there was some movement in the proportional breakdown.
  • Longer-tenor transactions (over five years) increased in volume and count by about 700%.

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 affect 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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