LIBOR to SOFR Transition Update – In Search of a Benchmark for Fixed-Rate Bonds
February 22, 2022
Fixed-Rate Pricing Convention Debate Continues
Beginning this year, federal banking regulators said that banks must stop originating LIBOR products. As is now well known, the recommended replacement rate for LIBOR is the Secured Overnight Financing Rate (SOFR), a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. While the transition brings significant changes to floating-rate CRE securitizations, primarily SASB CMBS and CRE CLOs, the impact to fixed-rate securitizations – both new issue and legacy – will be transformative as well.
Since 1998 (and up until this year), fixed-rate CMBS bonds were priced and quoted off a LIBOR swap curve (e.g., “S + 200” basis points) that incorporated a snapshot of the forward expectations for LIBOR for the floating-rate leg. For example, a typical 10-year CMBS bond was priced off a 10-year swap rate, based on a forward curve derived from LIBOR futures contracts, plus a spread. In addition, a significant number of fixed-rate CMBS investors hedged their positions immediately upon pricing using LIBOR swaps. With the transition to SOFR, a complex debate is underway – in both primary and secondary markets – as to what benchmark to use when pricing and trading fixed-rate securities.
CREFC Survey on Fixed-Rate Benchmarks Split amongst Market Participants
In late 2021, CREFC launched a survey asking members to rank their preferred benchmarks. The results showed that both Investors and Traders selected Treasuries (I- and J-curves) as their top choice at 78% and 77%, respectively, while Issuers and Lenders selected the SOFR swap curve (P-curve) by an equally decisive measure at 76%.
While a number of views were expressed supporting one pricing benchmark over another, some macro themes did emerge in favor of either Treasuries or SOFR swaps. Comments from Investors included a desire for consistency with other parts of the structured and corporate bond markets that price off Treasuries and some Investors felt moving to Treasuries would ultimately improve liquidity. Comments from Issuers and Lenders focused on the hedging component saying that SOFR offers a simpler and more precise hedge compared to Treasuries. Traders, meanwhile, pointed out that CMBS used to be priced off Treasuries and moving back to Treasuries would be the easiest way to transition.
Thus far, in 2022, the P-curve (i.e., SOFR swaps) has dominated the primary issuance market for CMBS. The primary reason being it is less pricey for issuers to hedge their interest-rate risk between loan origination and securitization with swaps versus Treasuries for a number of reasons including capital charges.
Meanwhile, many secondary trading desks have been using the J-curve (the on-the-run Treasury curve) to quote private-label CMBS spreads post the LIBOR transition. Market participants who trade bonds based on the J-curve make two distinct arguments in its favor:
- Allows for an easier comparison across asset classes (mainly corporate credit) and
- CMBS IO bonds have always priced to the J-curve, so there is familiarity.
Further complicating matters is the argument that fixed-rate CMBS should price to the I-Curve, or interpolated Treasury curve, which is a typical pricing convention for the Agency RMBS CMO space. Due to the various different duration profiles associated with this sector, there is a duration mismatch with the traditional Treasury curve, creating the need to price to the interpolated UST curve.
CREFC will continue to monitor the pricing conventions in both the primary and secondary markets, as well as continue its conversations with market participants. If you would like to schedule a call to discuss this matter, please contact Lisa Pendergast or Raj Aidasani.
CME to Present at Next CREFC LIBOR to SOFR Transition Call: CME Term SOFR
The next CREFC LIBOR Implementation Call, scheduled for March 2, will feature a presentation from CME Group titled “CME TERM SOFR: A CLOSER LOOK AT A NEW EMERGING BENCHMARK FOR THE POST-LIBOR WORLD.”
The presentation will provide an in-depth review of CME Term SOFR Reference Rates, including:
- The index construction methodology
- The role of CME Benchmark Administration in ensuring Term SOFR is robust and readily available under a variety of market conditions
- Fallback provisions and procedures to guarantee independent oversight and publication of rates
- Use cases, licensing requirements, and procedures, and
- Q&A
Speakers will include Gavin Lee, CEO of CME Group Benchmark Admin Limited, and Mark Rogerson, Executive Director, EMEA Head of Interest Rate Products, CME Group.
If you would like to join this call, please contact Raj Aidasani.