JPMorgan was in the market in late July with a $2.25 billion preferred stock deal. The non-call five notes pay a fixed rate of 5% until August 1, 2024, and then switch to a floating rate of three-month term secured overnight financing rate (Sofr), plus a spread of 3.38%.
The only problem is that three-month term Sofr doesn’t exist.
This is the first bank capital trade to reference Sofr. Bank of America issued a $1.3 billion Series KK preferred deal at the end of June, but that was still benchmarked to Libor.
Wells Fargo, JPMorgan, Citi, Goldman Sachs and Morgan Stanley have all issued senior notes that reference overnight Sofr, but not a term rate.
There are many good reasons to use an overnight rate in the cash market as well as for derivatives. It frees borrowers from exposure to bank credit risk and aligns lenders to the derivatives that they use to hedge their lending.
Indeed, using overnight rates is an opportunity to remove the basis risk that exists between the cash and derivatives markets.
For this reason, the development of alternative reference rates to replace Libor has so far focused on overnight substitutes.
And if there is one message that all regulators are now trying to ram home it is that issuers in cash markets must not wait for term rates to be developed before moving away from Libor.
But many are doing just that.
Compounding in arrears
The solution that has been put forward in the interim is compounding in arrears, whereby the average compounded interest rate over a period is taken and paid at its end. Both Goldman Sachs and Morgan Stanley have priced senior issues over a compounded Sofr rate.
However, the problem for many issuers is that compounding in arrears produces a backwards-looking rate. Libor is forward-looking, and many borrowers and lenders would like to keep things that way.
Knowing the interest rate you will be paying in advance is something it will be hard to persuade corporate treasurers to give up.
That won’t stop the regulators from trying.
“I think the prevailing view on our risk-free rate working group – the UK equivalent of the ARRC [alternative reference rates committee] in the United States – is that overnight Sonia [sterling overnight index average], compounded in arrears, will and should become the norm in bilateral and syndicated loan markets too,” said Andrew Bailey, chief executive of the UK’s Financial Conduct Authority (FCA) at a Securities Industry and Financial Markets Association (Sifma) Libor-transition event in July.
“The desire to use a common reference rate across linked markets, so that risk management is easier, hedges are less costly and basis risk is avoided, can be expected to exert strong gravitational pull towards the overnight rates in all markets.”
He added: “This context is one reason why we think that any firms still delaying transition until term rates arrive are making a mistake.”
I cannot guarantee that these efforts to produce term rates will be successful or the precise timing of their arrival- Andrew Bailey, FCA
But the market still wants term rates – as the JPMorgan trade shows.
What should they be based on? For Sonia, the decision has been made to price a term rate off Sonia swaps, a market that is already deep and liquid. The notional of outstanding cleared Sonia swaps now exceeds £10 trillion.
The problem for Sofr is that there is not yet enough liquidity in Sofr swaps to build a term rate based upon them. Sufficient liquidity will probably only come with central counterparties (CCPs) moving over from Libor to swaps in the second half of next year.
However, there is sufficient liquidity in futures and any term Sofr rate will probably be based on a combination of Sofr futures and Sofr overnight index swap (OIS) transactions.
But, according to Sifma, the ARRC, which is managing the transition away from US dollar Libor, is only targeting a finalized Sofr term rate by year-end 2021.
At the Sifma meeting, the FCA’s Bailey pointed out that open interest Sofr futures had grown to half a trillion US dollars. While liquidity in the Sofr futures market has improved rapidly, it is still not sufficient to create a robust, forward-looking term rate.
In the interim
What to do in the interim? ICE Benchmark Administration (IBA) is promoting its US dollar ICE bank yield index, which could combine a term Sofr yield curve and a bank credit-spread curve based upon transactional data.
But this would require banks to submit that data, which they may not be happy to do.
Could the JPMorgan preferreds meet their 2024 switch date without a term Sofr rate to move to? It is unlikely, but not completely impossible.
“I cannot guarantee that these efforts to produce term rates will be successful or the precise timing of their arrival,” warned Bailey at the Sifma meeting.
“That depends in part on ample supporting liquidity in Sonia and Sofr derivatives markets. That is a second reason we think that delaying transition until term rates arrive is mistaken.”
The JPMorgan deal has fallback language that provides for compounded Sofr, or another alternative rate, if there isn’t a term Sofr rate by then. But relying on fallback language in the documentation is a risky strategy and one which investors are anxious to avoid.
Despite the logical desire to align both cash and derivative markets to overnight rates, the regulators must come up with new term rates as a priority. Leaving this until the second half of next year is just too late.
Large parts of the loan market simply can’t use an overnight compounded rate and for them, no matter how much the regulators want to see a move to risk-free rates as the 2021 deadline for the end of Libor approaches, change will simply not happen until there is a term rate to transition to.