New risk-free rate fog begins to clear

Work to bring the new risk-free rates to the dollar and sterling bond markets began in earnest this year as several issuers brought notes linked to them. But 2019 could be where clarity emerges on which of the different structures will win out.

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The shift to a series of new risk-free rates (RFRs) by bond issuers and investors moved into gear this year. In dollars, Fannie Mae opened the Secured Overnight Financing Rate (Sofr) market by bringing a $6bn three tranche deal in July. But unlike the Sterling Overnight Index Average (Sonia) market, started by the European Investment Bank (EIB) a month earlier, differing approaches to Sofr bonds have appeared, meaning 2019 could be a year where competing approaches vie for the market’s approval.

In late November, EIB added to its pioneering Sonia trade with a $1bn October 2021 Sofr floater that was not only the longest dated Sofr trade to date, but also used a structure where the Sofr part of the coupon was compounded, rather than using a simple average, like Fannie Mae’s market opener and those that followed it.

That put it more in line with the Sofr swap market, where quotes are also on a compounding basis — something that market participants had been looking for.

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It would also match the Sonia bonds issued so far, which like the swaps market in that RFR, have also used compounding.

“In the UK, it’s fairly well aligned on a market convention perspective, with a small difference on the lookback length,” says Peter Green, head of public senior funding and covered bonds at Lloyds Banking Group in London, speaking before EIB printed its Sofr trade.

“There’s more efficiency than in the US, where Sofr swap quotes are on a compounding basis, whereas Sofr bonds are on a daily averaging basis. “We need to see a bit more development or alignments in the US between bonds and swaps. That would feed into the evolution of the cross-currency swap market.”

The Sonia bond market is ahead of Sofr in other ways too. The sterling rate was launched in 1997, before the Bank of England took it over in April 2016 and introduced a series of reforms in April 2018 — the month the Federal Reserve Bank of New York first began publishing Sofr.

The World Bank was in a strong position to compare the two markets, having been the first issuer to be present in both the Sofr and Sonia floater markets.

“The biggest difference between the two reference rates is investors’ exposure to them,” says Donald Sinclair, head of asset liability management, at the World Bank Treasury in Washington DC. “Sofr is brand new, while Sonia has been around for a while, so investors are more familiar with it. That also means that the infrastructure is more complete in the Sonia market. The biggest part of the work still needed, particularly for Sofr, is educating and attracting the investor base, building liquidity in cash and derivatives and establishing term rates.”

Euro behind

No trades linked to the new euro rate Ester have yet appeared — the European Central Bank is not due to start publishing it until October 2019 — but market participants are not concerned that Sonia and Sofr are ahead in development.

“There was more of a sense of urgency in dollars and sterling because of the threat of Libor discontinuation [at the end of 2021], whereas in the short term Euribor is expected to continue,” says Nathalie de Weert, senior capital markets officer, euro division, at the EIB in Luxembourg.

Other borrowers believe it is in markets other than bonds that the real heavy lifting is needed on the new RFRs.

“The impact of the new RFR is in my view much higher for the derivatives market, ALM and valuations,” says Otto Weyhausen-Brinkmann, head of new issues, capital markets at KfW in Frankfurt.

“In the bond markets we have seen a couple of issuances of Sofr and Sonia FRNs, but the vast majority is still fixed income.

“The clearing houses are probably the catalysts. First, are they able to clear derivatives with the new risk-free rates? The second point — which is not that obvious but is probably even more important — is the discounting with the new risk-free rate. This is quite a big change, moving from Eonia for discounting to Ester.”



Quotations in this article came from the GlobalCapital/TD Securities Risk-Free Rate Roundtable and Annual GlobalCapital/LBBW Euro SSA Roundtable.