Term SOFR execution charges in interest rate hedges
Hedging and Capital Markets
Real Estate | Kennett Square, PA
Term SOFR has emerged among non-Agency commercial real estate (CRE) lenders as the primary SOFR-based index of choice for their floating-rate loans. It is the NY Fed ARRC recommended fallback for non-agency CRE loans and the fallback under the LIBOR Act where the LIBOR Act applies. Regulatory recommendations and licensing restrictions limit the ability of hedge providers to manage their risk in providing Term SOFR hedges. These restrictions impact the cost of hedging Term SOFR loans. This piece discusses those costs and what CRE borrowers can do to mitigate them.
- Most non-Agency CRE lenders use 1-month Term SOFR as the index for their floating-rate loans.
- Caps and swaps on Term SOFR are available but hedge provider banks face restrictions on their ability to hedge their own risk related to Term SOFR in the interdealer market.
- These restrictions impact hedge pricing for CRE borrowers – interest rate swaps on 1-month Term SOFR will include a “charge” of ~3-6 bps that flows directly through to the synthetically fixed loan coupon.
- Chatham can assist borrowers in quantifying the impact of this charge on individual transactions and identifying options for reducing it.
Post the June 30, 2023 LIBOR "sunset" date, borrowers have gotten comfortable with SOFR-indexed loans, liquidity for hedges on SOFR is now robust, many lenders are in the process of transitioning legacy LIBOR loans to SOFR, and legislation has been passed which ensures that legacy LIBOR loans and hedges will automatically convert to SOFR if not otherwise amended.
The emergence of a Term SOFR “basis” which impacts hedging costs for CRE loans indexed to Term SOFR (the predominant version of SOFR used in non-Agency CRE debt) has been a challenge, post-LIBOR. This basis has its roots in restrictions on interdealer trading of Term SOFR derivatives. While dealer banks can offer Term SOFR caps and swaps to CRE borrowers, they themselves can’t hedge their own risk with Term SOFR derivatives in the interbank market. This forces them to hedge their risk using derivatives indexed to an alternative version of SOFR (typically SOFR compounded in arrears). These versions of SOFR can diverge. When this divergence occurs, a dealer’s hedge isn’t perfectly effective, resulting in basis risk held on the dealer’s book. Dealers must reserve against this risk by charging CRE borrowers more for their hedges.
This pricing impact is more pronounced in interest rate swaps. We’ve observed dealer banks providing swaps on Term SOFR charging an additional 3-6 basis points in the swap rate depending on the bank and the swap structure. There is a pricing impact for interest rate caps as well, expressed as an additional charge, in dollars, which can be larger or smaller depending on how “in-the-money” the cap is (i.e., how low or high the strike rate of the cap is relative to the SOFR forward curve). Unfortunately, these pricing impacts are not consistent between banks and currently can’t be verified through any third-party data providers, though the recent change in regulatory guidance permitting dealers to trade Term SOFR-SOFR basis swaps with non-dealers may change that.
In practice, this affects CRE borrowers that are putting new hedges in place or that are restructuring legacy LIBOR hedges as follows:
- Swaps on new loans indexed to Term SOFR and modifications of legacy LIBOR swaps will typically be subject to a 3-6 basis point execution charge that would not be observed with an alternative version of SOFR. This results in a higher all-in coupon on the loan relative to alternative versions of SOFR.
- Premiums on new caps indexed to Term SOFR or costs associated with converting legacy LIBOR caps to Term SOFR will include a component attributable to this basis risk. The exact amount will be driven by the size and tenor of the cap and how high its strike rate is.
In this context, we are advising clients as follows:
- Please contact us for any new financings, or any conversions of legacy LIBOR financings that involve caps or swaps so we can help you evaluate the potential impact of Term SOFR execution charges on deal economics.
- For new financings involving a swap, or conversions of legacy swapped LIBOR floaters to SOFR, it will typically be economically advantageous to use daily SOFR (rather than Term SOFR) as the loan index.
- For new financings involving an interest rate cap, the choice of daily SOFR or Term SOFR will usually be less impactful.
- In situations where a legacy LIBOR loan with a cap is being converted to Term SOFR, a borrower should consider the pros and cons of incurring the expense to convert the cap to Term SOFR relative to letting the cap fallback to SOFR compounded in arrears (per standard ISDA fallback provisions). The former approach ensures a perfect hedge, but may come with a conversion cost; the latter may have a lower conversion cost, but will create a mismatch between the SOFR index used in the loan and the cap. This may cause the cap to be an imperfect hedge in situations where there is a divergence between spot SOFR expectations as implied by Term SOFR and actual spot SOFR rates.
Want help mitigating your costs hedging with Term SOFR?
Contact a Chatham expert today.
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.23-0104
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