Watching three core markets implement new risk-free rates almost simultaneously is a good opportunity to learn about the character of the respective investor bases and the approach of their regulators.
So far, they have managed with a minimum of disruption, but the process is by no means over. €STR, the eurozone’s preferred replacement for interbank offered rates, has scarcely begun its journey and, while the UK’s Sonia has rapidly achieved widespread adoption, the same cannot be said for Sofr FRNs in the US.
Sofr and Sonia both arrived as SSA benchmark rates in mid-2018, but since then, sterling investors have plunged straight into Sonia, while in the dollar market, Sofr is still struggling to gain momentum.
While some £33bn of sterling issuance used Sonia in 2019 (up from £6.9bn in 2018), Sofr is lagging behind with only $20bn of which only just over $2bn came from sovereign, supranational and agency borrowers.
Sonia has swiftly become a staple, with bookrunners and investors confidently embracing the central bank’s new system. “It’s worth noting that the number of bookrunners on Sonia deals this year has been 25, which is the majority of underwriters in the sterling market and more than double the number of bookrunners last year,” says Sean Taor, head of European debt capital markets and syndicate at RBC Capital Markets in London.
Since the European Investment Bank pioneered the move to Sonia-linked issuance in June 2018, almost every big supranational has issued a Sonia floating rate note, including World Bank, the International Finance Corporation and the Asian Development Bank. In 2019, several public sector agencies and even a sub-sovereign also entered the Sonia market.
A key driver to the rapid growth of Sonia FRNs has been the swift decision to adopt and stick to a consistent structure, according to market participants. Every transaction has come with the same coupon calculation comprising a daily compounded coupon and a five day lookback.
“The work that went into getting the structure right for the first couple of issuances helped the market find a standard quickly, giving both issuers and investors confidence in the format and now thanks to that tried and tested format Sonia FRNs have become the norm,” says Charlotte Bacon, head of the liquid asset portfolio at Lloyds Bank in London. “The Sonia FRN market is flourishing, and I only expect that to continue.”
The US’s Sofr can boast no such uniformity, with many issuers taking their own approaches to the new rate. “While there has been one calculation method for all Sonia bonds, there have been seven or eight different calculation methods in the Sofr bond market and that has perhaps not helped adoption,” says Taor.
The failure to land on a market standard for Sofr FRNs has been a factor as to why its issuance has lagged behind Sonia FRNs, says Bacon. “Until there is a standardised approach I think the format will struggle. As investors, we would like to see the Sofr market follow Sonia in terms of structure.”
But a consensus is building. The latest Sofr trades indicate that public sector borrowers are favouring the same coupon calculation used in the Sonia market and matching the Sofr derivatives market.
Another big step in the development of the Sofr FRN market awaits, with the New York Fed aiming to start publishing backward-looking average Sofr rates by the first half of 2020.
“When the Federal Reserve Bank of New York starts publishing a backward-looking Sofr average rate, that will be helpful in clearing up the discrepancies of calculating the compounded coupons,” says Mark Byrne, a bond syndicate official at TD Securities in London.
Currently, the US Federal Reserve only publishes the daily overnight average rates of Sofr. It does not publish the compounded rates — used by borrowers issuing FRNs linked to the new benchmarks. That leaves issuers to calculate the compounded rates themselves and this has proven to be a serious headache.
The Bank of England and European Central Bank also only publish the daily overnight average rates for Sonia and €STR, respectively. The ECB began publication in October.
Public sector borrowers say that when they paid out the first coupons of their Sonia-linked bonds, the paying agent, swap counterparty, Bloomberg and the issuer’s own internal systems all produced different figures as they were all rounding to a different number of decimal places.
Although Sonia has achieved mainstream adoption without a central bank-published average rate, introducing one would likely smooth the implementation process for all three rates.
“Over time perhaps the Bank of England and European Central Bank may look at doing something similar and it makes sense for them to,” says Byrne.
In September, the Federal Housing Finance Agency provided another positive development for the Sofr transition with a letter to the Federal Home Loan Bank systems instructing them to stop investing in assets tied to Libor by the end of 2019 with a maturity beyond December 31, 2021.
As of March 31 2020, FHLBs cannot enter Libor-based transactions involving advances, debt, derivatives, or other products with maturities beyond December 31, 2021.
“That’s a very proactive approach and the strongest regulatory action we’ve seen so far,” says Byrne at TD Securities.
While around 36% of FHLB FRNs are already linked to Sofr, the FHFA’s instruction is expected to accelerate the issuance of more Sofr FRNs by the FHLB.
€STR arrives
In 2019, there were the first few FRNs linked to €STR, the recommended replacement for Eonia, which will be discontinued on January 3, 2022. The ECB took its time in developing €STR, using a typically gradual, step-by-step approach. But investors seem willing to engage with the result.
“€STR is at the very beginning,” says Adam Kurpiel, head of rates strategy at Société Générale in Paris. “But I believe that the transition will be smooth and easy. The next big step will be the switch to €STR flat discounting at the middle of 2020. That will be a major step in the transition away from Eonia to €STR.”
In September, L-Bank raised €250m with the first €STR-linked transaction.
The deal came a few weeks before the European Central Bank started publishing €STR rates on October 1. However, the two year FRN was priced with a settlement date of October 8, which made the trade possible.
“Both the L-Bank and EIB transactions proved that there is demand for euro FRNs at the right spread,” says Taor. “What was encouraging with the EIB trade was that it achieved an order book of over €2bn for a €1bn deal. It also came with the same coupon calculation as the Sonia and EIB’s Sofr-linked FRNs. EIB has been very thoughtful in taking the lead in using similar calculation language across all the risk-free rate currencies they have issued in.
“We have also executed a risk-free rate test trade in Canadian dollars for EIB to make sure settlement and payment systems work. Again EIB used the same coupon calculation in Canadian dollars as they have done in other RFR currency issuance.”
In November, KfW followed with a €1bn three year €STR-linked FRN. The deal came with a spread of 10bp over €STR, making it the tightest €STR FRN to be issued so far. Crédit Agricole, Deutsche Bank and UniCredit were the leads.
While Eonia and €STR both rely on transactions from the euro overnight unsecured money market segment, they differ in many other ways.
Eonia is administered by the private sector through the European Money Markets Institute and relies on voluntary data. €STR is governed by the ECB and is based on individual unsecured overnight borrowing deposit transactions.
Legacy conundrum
As borrowers move to the new risk-free rates, there is uncertainty as to what will happen to outstanding Libor FRNs.
“In the SSA market, the vast majority of Libor FRNs will mature before the end of 2021 or have robust fallbacks,” says Byrne. “But there are smaller private placements that go past 2021.”
One way to address this would be simply to change the reference rate on the outstanding FRNs from Libor to the new risk-free rates, as long as investors give permission to do so.
Associated British Ports became the very first issuer to request a switch from Libor to Sonia in 2019. Other issuers have followed, including Lloyds Bank, which completed the first interest rate conversion from Libor to Sonia in the UK covered bond market.
“The recent consent solicitations to convert Libor FRNs into Sonia FRNs have been a good development and I would hope that would continue for all outstanding sterling Libor FRNs maturing post the 2021 deadline,” says Bacon.
In addition to a consent solicitation, there are other options.
“One solution is to push back the deadline, while another be would to allow Libor to survive under a different format away from the dependence of bank contributions,” says Kurpiel. “For this to be done, it would need the active involvement of legislators.
“Everyone agrees that the new risk-free rate benchmarks are the way forward but there is uncertainty about the legacy transactions. At this stage there are more questions than answers.” GC
