The same, it seems, is true when it comes to structuring bonds linked to post-Ibor risk-free rates. The first episode, covering 2018-19, was often confusing for participants, with several different methodologies and formats competing for attention. The 2020 version, however, presents a simpler story, with the introduction of official ‘golden source’ indices making it much easier to follow along.
One thing has not changed, though. The European Investment Bank took a starring role first time around to establish the market — issuing the first ever Sonia, Sofr and €STR floating rate bonds in 2018 and 2019 — and has now again been cast in the leading role as the market becomes standardised.
The key action took place on February 12 when the Federal Reserve Bank of New York, following recommendations from the Alternative Reference Rates Committee, began publishing a compounding Sofr index and new 30, 60 and 90 day Sofr averages.
“As soon as we learned that the central banks were working on these issues we wanted to be at the forefront of development and provide the first template that other issuers could use in these markets,” says Xavier Leroy, capital markets officer at the EIB in Luxembourg.
The Sofr and Sonia compounded indices measure the cumulative return of a unit invested at the risk free rate, with its starting value set at 1.0 on April 2, 2018 for Sofr and set at 100 on April 23, 2018 for Sonia, both to eight decimal places.
Previously, different issuers had different ideas on how to calculate payments — using different lag structures, or lookbacks. Because the central banks publishing the Sofr and Sonia rates were only providing daily, overnight averages, it was up to market participants to agree calculation formulae for term products. Investors found themselves having to tweak systems in order to participate in a deal, with no certainty that the next deal would use the same calculation.
“The publication of the index provides a ‘golden source’ where you can see exactly what is required,” says Leroy. Two weeks after the NY Fed began publishing, the EIB launched the first Sofr deal linked to the new index, issuing a $1bn (no-grow) four year benchmark at 28bp over compounding Sofr.
“It was very important for us to do a landmark transaction that could be used as a reference because although an index simplifies life for many people, not every investor was ready to use it,” says Leroy. “The fact that an issuer like the EIB comes to market and says ‘look, we believe in this, we believe it is the future, and this is a how a bond should look’, then people consider it very seriously.
“They might not be equipped yet to buy such a transaction but once they have seen it is successful, they will make the necessary adjustments for the next one. That’s how you move the market and how you develop the market. It benefits smaller issuers because then when they come to the market, investors are ready and they can access a broader number.”
One key feature of using an index instead of averaging is that it naturally promotes using a ‘shift’ instead of a ‘lag’ methodology, and is easier to standardise. In a lag structure, payments depend on the number of business days in the coupon period and were often used in conjunction with lockouts, so that a rate could be used on non-business days in the period. In a shift structure, it is the observation period that matters, and this can easily be defined with start and end dates ‘shifted’ back by a fixed number of days, allowing hedges to be easily aligned.
In the US, using lags resulted in as many as seven or eight different conventions being used, while even in the UK, where issuance coalesced around using a five day lag, there were problems.
For instance, every party to a transaction in effect had to make their own calculation of payments in their own systems. And while that should not be a problem — it is, after all, as simple as typing a formula into a spreadsheet and specifying the parameters — it was leading to reconciliation difficulties for reasons as basic as rounding errors putting payments pennies out.
“The calculations were not complex in themselves but many back office systems were not really designed for them. An index is a much simpler solution,” says Richard Teichmeister, head of new products and special transactions funding at the EIB.
The EIB also moved quickly after the Bank of England began publishing its daily index on August 3, announcing a new £1bn (no-grow) five year benchmark on August 27. With initial price thoughts of 30bp area over compounding Sonia, the deal got indications of interest of £1.6bn by the time books were opened the following morning, and orders reached £2.3bn. Pricing followed 2bp tighter, at 28bp over.
Now, not only was there a new, easily accessible standard in sterling, but harmonisation across sterling and dollars. If there was a drawback to the introduction of a new format, it was simply that some investors, having invested in the old format, were not prepared to go through the process of updating again before being convinced indices would be a success. “Now they’re ready for the latest developments,” says Leroy. “Things should now be more stable and people will catch up.
“We strongly believe that it’s a really good solution and it’s very simple to use.”
From now on, the post-Ibor market will not be subject to the sudden plot-twists that had previously so annoyed some fans — but they can depend on the EIB remaining a leading actor.
