There is a growing debate emerging among financial borrowers that issue high-grade bonds linked to the Secured Overnight Financing Rate which is leading to uncertainty about the best route forward for the market as it transitions away from Libor.
Two different structures for how to calculate interest rate payments under SOFR are vying to set the standard in the market, but remain equally divided among issuers and the banks bringing deals to market.
SOFR-linked issuance in the US bond market has been active since the beginning of the year and the debate between the two interest rate payment schemes came to a head on February 5 when two smaller regional banks — Synovus and First Republic — came to market on the same day with opposing structures.
New bond structures are needed because Libor is forward-looking, but SOFR is a daily compounding backward-looking rate that is averaged out over the prior pay period to calculate the interest payment on the bonds.
Issuers require about two days to calculate what the average was for the quarter, calculate it across their portfolio of SOFR notes and send payments to investors.
So the question has become: when is the final day to calculate the average?
In one corner: First Republic issued with the structure known as a "payment delay", which was first introduced by Morgan Stanley in June 2019.
Payment delays mean that investors receive their quarterly funds two days after they would normally receive interest rate payments on the bonds in their portfolio.
In the other corner: Synovus backed a structure called a "backward shift", which was first introduced by Goldman Sachs in May 2019.
A backward shift cuts off the average SOFR calculation two days before the quarter closes, which allows investors to receive their payments on time, but pushes two days of potential volatility in SOFR rates to the following quarterly calculation.
TWO DAYS IN LIMBO
Two days may seem insignificant in the grand scheme of things, but after the repo market sent SOFR rates surging to a record high 5.25% on one day in September only to fall back to 1.86% the next, bond markets started to worry about these discrepancies in the average SOFR calculation.
Investors are also seeking a structure that best aligns with derivative swap markets, but both sides are claiming their structure is best suited, said Daniel Bruzzo, investment-grade corporate debt strategist at Amherst Pierpont.
"I guess time will tell - or at least the markets' perception will tell - which is best," he said.
"For the time being the traders involved in that market are doing their best to see what best aligns with their systems for interest rate swaps."
One banker said the payment delay structure seemed to take the lead in the early rounds last year as it received backing from Citigroup, Deutsche Bank, MUFG Union Bank and Toyota.
But the backward shift is punching back as five borrowers have issued in the format since the start of January: Goldman Sachs, Credit Suisse, Toronto-Dominion Bank, MetLife and Jackson National Life.
"The best thing for the SOFR market is more consistency," said one FIG director of debt capital markets from a bank that backs the backward shift structure.
"We hope the bulk of the market moves in one direction or another and obviously we've taken a bit of a view on what we think is a preferable structure. Not to say the Morgan Stanley one is wrong, but there isn't a convention right now and we're searching for one."
Despite all the fuss over this structure among the banks, investors have not taken sides in the debate as neither structure is receiving a price advantage.
In fact, the recent issuance of Libor notes suggests there is little pricing advantage for banks to make the leap into SOFR bonds at all in the near term, even as the December 2021 Libor phase-out deadline approaches.
For example, US Bank was not penalised when it priced a two-year floater in January at three-month Libor plus 18bp. In fact, it priced 13bp tighter than its two-year floater from a year ago as investors were satisfied with the fall-back language provided by the Alternative Reference Rate Committee.
Investors also noted that issuers had not priced SOFR floaters at materially tighter spreads than they would otherwise achieve through a Libor back-end.
Furthermore, Toyota issued a private placement SOFR note last year but opted for Libor this month when it priced a US$1.1bn 18-month floater.
"In the corporate market there is no real observable price sensitivity to the differences in these dividend-determination approaches," Bruzzo said.
"There has been no sensitivity for the deals set to SOFR versus the deals set to Libor versus those set to constant maturity Treasury, and we've seen all three among four issuers this year."