SOFR and credit spread – Not as simple as it seems

Chris Dias, principal and global Libor solution co-lead at KPMG, explores how the market will adjust as liquidity grows and why firms must resist the temptation to default to existing processes for determining credit spread and re-think the traditional approach

Chris Dias, KPMG

The adoption of the secured overnight financing rate (SOFR) is forcing firms to think about credit spreads and how to apply them to new and old transactions While some firms may default to existing processes to determine credit spread, the structural and behavioural differences between Libor and SOFR are compelling others to rethink the traditional approach. Any reformulation of a firm’s credit spread methodology will also require a reassessment of pricing strategies and conduct risk implications, in addition to operational impacts

Historically, Libor has adjusted – albeit artificially through expert judgement – either up or down depending on perceptions related to the economy, perceived stress, liquidity and market demand. The fact Libor is an unsecured rate with an implied credit component allowed its contributors to factor in adjustments warranted by prevailing conditions. Banks could take solace in knowing that, if their cost of funds rose in times of stress, a compensating rise in lending rates would also occur protecting interest margin. 

Replacing Libor with SOFR could jeopardise this long-standing paradigm. Very simply, SOFR is an average rate – calculated by the US Federal Reserve – built on secured repo transactions. Because the underlying transactions used to derive SOFR are collateralised, SOFR tends to decline in times of market stress and dislocation, which contrasts with how Libor responds in similar market conditions. Recent stressed market conditions have only served to emphasise the potential for divergence between the two benchmarks, so it is clear that the underlying difference between the rates means there will need to be careful thought regarding whether to include a credit component for this difference and and, if so, how?

This flight-to-quality phenomenon coupled with the market-driven nature of SOFR introduces the possibility that SOFR rates may go below zero – a circumstance that has never happened with Libor. Although the published rate has yet to register a negative rate, there have been several underlying secured repo transactions – general collateral, not specials – which have yielded a negative return. The potential for this outcome has banks scrambling to understand where and how a floor can be implemented or if one can be implemented at all.

Given the diverging behaviour between rates, many banks are exploring the spread component to best mitigate the ‘rate differences’ risk. Some banks have started looking at alternatives to SOFR, preferring to explore a rate much closer in construct to Libor to solve the credit spread differences. Several rates are being considered because they have an implied credit component that, much like Libor, will be affected by general bank credit quality. While these alternatives seem to have some interesting features, they are not without issues. Given they are not identical to Libor, some adjustments will need to be made to the underlying rate; the underlying volume will need to be International Organization of Securities Commissions-compliant, and the question of a benchmark-quality term structure will need to be solved. 

Other benchmarks might be plausible, but not probable. Banks will need to consider other alternatives to compensate for differences between Libor and SOFR. The Alternative Reference Rates Committee (ARRC) working group and industry bodies have explored the differences between the two rates deciding that, at least for legacy trades, an adjustment was required to recognise the credit component in Libor. The ARRC has published a spread adjustment methodology based on a five-year historical median between Libor and compounded SOFR. The static adjustment could be applied to all legacy transactions in an attempt to offset the structural difference between the two rates. While this addresses a specific concern, it does not help with the behavioural issues that banks are grappling with. The same can be said for any static spread applied to SOFR, whether for legacy transactions or new transactions. 

Banks are also now trying to explore other ideas such as premium spread add-ons, dynamic spreads and fee levies. All have some merit but do not perfectly address every concern. The drive to create a robust market-driven benchmark is not without growing pains, the market will adjust as liquidity grows and the market matures.

The author

Chris Dias, Principal,
Global Libor Solution Co-Lead

Chris Dias is a principal in KPMG’s modelling and valuation group, serving financial services companies as a risk practitioner and strategic adviser. He is an accomplished professional with over 30 years of international experience in financial markets and now serves as a global Libor solution co-lead at KPMG

Libor Risk – Quarterly report Q2 2020
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