Is SOFR replacing LIBOR as elected in the bond market?

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With the termination date of the remaining parameters of the London Interbank Offered Rate (LIBOR) a year away, it is surprising how much work remains to be done and how different market participants are reacting to USD LIBOR and its successor, Secured. Overnight Funding Rate (SOFR). While industry players push for the development of a derivatives market linked to SOFR, the bond market is less frequently discussed. However, debt issuance is also an essential market indicator when evaluating a benchmark rate like SOFR.

For the analysis presented here, we collected new debt issuance data from January 2019 to January 2022, compiled by issuer type, coupon structure and maturity:

  • Transmitter types: company, agency and sovereign
  • Coupon structures: fixed rate and floating rate (LIBOR, SOFR, Term SOFR, SOFR Average, other alternative rates (Effective Federal Funds Rate (EFFR), Bloomberg Short Term Bank Yield Index (BSBY), American Interbank Offered Rate (AMERIBOR)), and coupon staggered)
  • Maturity Terms by Years to Maturity (YTM): short term (0-2), medium term (2-5) and long term (5+)

The data indicates that SOFR debt issuance is increasing, especially since mid-2021, thanks to the SOFR first initiative. However, new issues present a different landscape than LIBOR, which may imply the future of the SOFR bond market.

Corporate issuers are reluctant to extend the depth of maturity of the SOFR FRN

We are seeing a slow transition of corporate new issues away from LIBOR and proactive activity in various alternative rates. Total issues and issues of variable rate securities (FRN) have remained stable in recent years; SOFR issuances in 2021 are approximately 8% larger than LIBOR issuances in 2019 in terms of issuance amounts. That said, private issuers are actively exploring different types of benchmark rates when issuing FRNs. These alternative reference rates are generally fixed in advance, in relation to the SOFR fixed in arrears. As shown in Figure 1, forward SOFR emissions represent approximately 7% of total FRN emissions each year. FRN issue amounts referencing other alternative rates were $1 billion to $2 billion in 2020 and 2021, respectively.

As shown in Figure 2, each maturity represents an equal share of total issuance in the case of LIBOR. On the contrary, SOFR new issues seem to be mainly short-term. Long-term SOFR issues represent about 19% of the total, but most of them mature in less than 10 years. There have been calls for a prefixed SOFR-based index since the start of the transition away from LIBOR. One of the obvious reasons for this is that market participants have become accustomed to fixed LIBOR in terms of technology, operations and commerce. Besides the allure of the upfront, there are several explanations for the show’s landscape:

  1. Issuers are not motivated to issue longer-term bonds. With the current state of the economy and rising inflation, it is riskier to initiate longer-term bond trades, as investors demand higher returns when inflation rises. However, Figure 3 shows that the yield on longer-dated bonds is much less sensitive than the yield on shorter-dated bonds. Additionally, a tightening policy by the Federal Reserve could lead to an inverted yield curve. Figure 4 suggests that US Treasuries curves have started falling over the long term since January 2022.
  2. The availability of other alternative rates expands debt issuance options, while also casting uncertainty on the long-term benchmark rate. In addition to the more popular Derivative Term SOFR and Average SOFR calculated on historical rates, there are EFFR, BSBY, and AMERIBOR with approximately $1.3 billion in medium and long-term bonds issued in 2021. emission is much lower than that. SOFR, but the trend has been to issue longer-dated SOFR-linked bonds over time.
  3. There is still a long way to go before reaching a liquid SOFR market. The use of SOFR in interest rate swaps has increased over the past year with broad offerings in terms ranging from a few months to over 30 years, but we are not seeing the same depth of maturity in bond offers. This is interesting because interest rate swaps are often used as a hedging tool against bond risk exposure. Lack of liquidity in the long-term bond market cannot provide a meaningful SOFR bond yield curve and term premiums, further discouraging issuers and investors from entering the market.

Therefore, the term SOFR meets to some extent the need for long-term bonds. However, forward SOFR will not be a perfect complement to the maturity spectrum of SOFR bonds. As discussed earlier, paradoxes arise when market participants aim to develop both SOFR and forward SOFR in spot and derivatives markets.

composition-of-maturities-by-type-of-benchmark-rate

yield-by-bonds-benchmark-us

US-treasury-spot-rate-curve-sample

Agency issuers abandon LIBOR

Agency issuers dipped into SOFR debt as early as 2019, and the amount of issuance peaked in 2020. SOFR issuance fell in 2021, as did the overall size of FRN issuance.

LIBOR issues have effectively dropped to zero since 2019, indicating that US agencies are leading the transition movement. However, the willingness to issue SOFR debt has weakened, even with a relative increase in the issuance of laddered coupons and other alternative rates. The lack of clarity on the term SOFR has led to hesitation on SOFR issues. One thing about a laddered coupon bond and a LIBOR bond stock is that the coupon rate is fixed in advance. The tiered coupon is the only type of coupon that shows an increase in the amount of issuance, while the total amount of FRN issuance decreased by approximately 70% from 2020 to 2021. With the term SOFR unveiled and officially approved in late 2021, we will continue to monitor the agency’s show. for 2022 – this could become a competition between SOFR and Term SOFR.

agency-frn-emission-compositions

Sovereign issuers away from SOFR issuance

Sovereign issuers are clearly reluctant to reference SOFR. Total SOFR issuance from 2019 to January 2022 was just $0.5 billion, compared to LIBOR issuance of around $4 billion. With the end of LIBOR issues there has been an increase in laddered coupon issues, but it is difficult to conclude if there is a direct link between the two. There is an argument that sovereign, supranational and agency (SSA) issuers are the best candidates to lead SOFR bond maturity offerings. The World Bank and other agencies have launched billions of seven-year SOFR bonds in recent months, which should kick things off.

Overview: SONIA is doing well, but TONAR is struggling

Since all GBP and JPY LIBOR duration parameters ceased on December 31, 2021, the Sterling Overnight Index Average (SONIA) and Tokyo Overnight Average Rate (TONAR) bond markets can serve as good indicators of the future of the bond market. SOFR.

The UK bond market is smaller than the US market. The amount of corporate issues in the UK is around 8% of its US counterpart, while the amounts of issues in SSA are still less than 8%. UK SSA issuers are not enthusiastic about FRN issuance, let alone SONIA issuance. The SONIA corporate issue appears more organic:

  • The issue amount of SONIA in 2021 is equivalent in scale to the issue amount of LIBOR in 2019, which implies an effective transition
  • Each maturity term takes an equal share in SONIA’s issuance, suggesting a deep maturity offering
  • The SONIA seems to be strongly recommended as a reference rate with a minimum issuance of SONIA at term and no other alternative rate in consideration

The Japanese bond market is closer to the US market in terms of issue amounts. Several benchmark rates in Japan have gained popularity since the transition from LIBOR, including the Tokyo Interbank Offered Rate (TIBOR), Tokyo Term Risk Free Rate (TORF), and Treasury rates. As in the UK, SSA issuers in Japan are not interested in issuing FRNs. With regard to corporate emissions, we have observed the following trends:

  • The transition is very slow. Around 18% of FRNs issued in 2021 referenced LIBOR. According to the fallback cascade recommended by the Bank of Japan, the first level will convert LIBOR to TORF.
  • There does not appear to be any motivation to issue TONAR debt. There is a $1 billion bond issuance on TONAR in 2019, followed by zero in 2020. In 2021, there was a single TONAR bond issuance by Mitsubishi Corporation of $130 billion, or approximately 3 % of FRN issue.
  • TIBOR maintains its popularity as Treasury rates rise. TIBOR issuance has remained steady at around 5% of FRN issuance each year. However, Treasury-related issuances accounted for around 6% of FRN issuances in 2020 and rapidly increased to 53% in 2021. In January 2022 alone, the amount of Treasury-related issuances was $95 billion, compared to zero emission of TONAR.

The US bond market appears to be between the UK and Japanese markets. The US market picks up SOFR issues, but lacks the depth of maturity as seen in the UK market. There are several alternative rates that are gaining popularity, but nothing is as strong as TIBOR or Treasury rates in the Japanese market.

Conclusion

As Rome was not built in a day, there have been several milestones in the development of the SOFR bond market, but this could be the start of the journey. While we would like to see a deeper SOFR bond market, the development may not go the way of LIBOR. With forward SOFR and other alternative rates actively in use, the future of the FRN bond market may be more diverse but more complicated in many ways.

This blog post is for informational purposes only. The information in this blog post does not constitute legal, tax or investment advice. FactSet does not endorse or recommend any investment and assumes no responsibility for any consequences related directly or indirectly to any action or inaction taken based on the information in this article.

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