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SOFR: What’s Next? - High Quality Credit Spreads

FICC Podcasts March 24, 2021
FICC Podcasts March 24, 2021

 

Dan Krieter and Dan Belton discuss their two preferred trade ideas in the current range-bound environment for credit spreads before turning to recent developments in the transition from LIBOR to SOFR. Topics include the recent announcement that the ARRC will not be recommending a term rate for SOFR, a possible credit-sensitive benchmark, and SOFR FRN issuance.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello, and welcome to Macro Horizons High Quality Spreads for the week of March 24th. SOFR, what's left? I'm your host, Dan Krieter, here with Dan Belton, as we provide a couple of trade ideas that will likely benefit from the range bond trading environment we expect in the near term. Finally, we discuss some recent SOFR market headlines and what's left in the transition from LIBOR to SOFR.

Dan Krieter:

Each week we offer our view on credit spreads, ranging from the highest quality sectors such as agencies and SSAs to investment grade corporates. We also focus on U.S. Dollar swap spreads and all the factors that entails including funding markets, cross currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode. So please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or email directly at dan.krieter, K-R-I-E-T-E-R @bmo.com. We value and greatly appreciate your input.

Disclosure:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Dan Krieter:

Well, Dan, last week we had a reaction to the FOMC episode where we talked about what the Fed did at their meeting last week and what it meant for credit and swap spreads. And I don't think the view has changed much in the week since the Fed's last meeting. Actually, I don't think the market's changed much since last week either.

Dan Belton:

No, pretty range-bound in terms of spread trading, the biggest source of uncertainty when we recorded our last episode had to do with the SLR exemption and the potential expiration. The Fed announced on Friday, of course, that it would allow the SLR to expire. But there's still some more uncertainty on that front with their potential for a permanent change to that leverage ratio.

Dan Belton:

However, spreads are still unchanged. We're about a basis point better over the past week. And we're still looking at this as a push-pull dynamic, where we have technicals that are weighing on credit spreads with heavy corporate supply continuing to come in and primary market statistics getting a little bit worse, but still overall, fairly constructive.

Dan Belton:

And then increased Treasury yields. The sell off in yields has abated a little bit over the past few sessions, but so those higher level of Treasury yields is going to warrant wider credit spreads. Then in contrast, we have improved fundamentals. You see that through economic growth expectations and then also through better rating actions. So in a nutshell, I think we're still neutral on credit spreads.

Dan Krieter:

Yeah. And ultimately the next significant move may well be wider. I think there are certainly some risk factors out on the horizon, including some of those Democratic platforms now being brought to the front of the agenda, now that stimulus has been passed talking here about tax increases, both corporations and individuals. Also, potentially talking about some reductions in Fed accommodation towards the end of the year.

Dan Krieter:

Also, even just on the economy front, I think we're priced to perfection here, everyone pricing this really, really strong economic reopening. And I agree that's likely going to be what happens, but we're probably going to hit some rough patches along the way. I mean, for the last year the economy has been supported by an absolutely mind boggling amount of stimulus. And that's going to go away at some point.

Dan Krieter:

At some point the economy's going to have to stand up and walk on its own. And as people have to start paying their mortgage again, as forbearance programs end, as extraordinary unemployment benefits expire, as businesses that have held out this entire time waiting for that business to come back. Maybe it's not going to for all businesses. As we start to see some of that stuff potentially not meet expectations in the summer months, it could be an impetus towards higher credit spreads.

Dan Krieter:

But all three of those factors we discussed, that's probably going to be in the future. In the near term, for really the next probably two months, if not three months, I think that push-pull dynamic you laid out, Dan, is probably going to be what continues to drive the market. And we're just going to see this sideways range-bound type of environment where it'll drift higher some days and drift lower to the bottom of the range on others. And you're going to really make money by, first of all, playing that range and buying and selling at the extremes. But also by finding individual investments that may out perform even if the absolute level of spreads don't change much.

Dan Krieter:

And to that end we're favoring this credit barbell strategy where we're going to try to avoid the middle of the credit tier, the double A rated or high single A rated corporations where the risk reward proposition just isn't as good. If the upward potential for spreads to continue narrowing is gone, maybe you want to look further down the credit curve and pick up incremental yield. But that might be too risky for you, in which case, maybe going to the ultra high end of the credit spectrum toward the SSA agency space is where you want to be and just reduce risks. It's that middle part of the credit spectrum here that really doesn't have a very attractive risk reward proposition.

Dan Krieter:

So in that credit barbell strategy, I thought maybe we could just spend a second talking very briefly about a couple of trade ideas we might like in that area. So Dan, what's a trade idea out the credit curve that you like in the months ahead.

Dan Belton:

Yeah, Dan, just a minute ago I talked about the improved fundamentals in the corporate market, and particularly with grading actions turning positive, really for the first time since the pandemic. That should bode well for triple B names in the investment grade corporate market. Improved fundamentals, as measured by rating actions, actually have a very strong correlation to credit spread compression.

Dan Belton:

So it might be a little bit counterintuitive that we've turned neutral on outright credit, but we're still recommending some spread compression. I think that's going to be the case as long as we have this push-pull dynamic between technicals and fundamentals. And there's still some value to be had in the triple B space with these corporations that are still impacted by the pandemic trading at wider levels than pre-pandemic. So we looked at this in our weekly last week and I'd urge readers who are interested to take a look at that for some more details.

Dan Belton:

So we looked at the sectors that are still trading generally wide to pre-pandemic levels. We came away with a few recommendations for this trade. Specifically, we like the leisure sector. Telecoms, transportation, utilities are also still trading wide to pre-pandemic levels. And as long as we have this credit spread compression that we're calling for, we think that these are likely to outperform at least in the near term. And there's going to be some risk to these sectors, longer term. And there's certainly some structural risk that the pandemic has brought, and that's likely to bring some lasting changes.

Dan Belton:

But in the near and medium term, we don't expect a significant wave of rating downgrades to disrupt this path of credit spread compression. So we like triple Bs and we like some of these names that are still trading cheap to pre-pandemic levels. But we recognize that this is not a trade idea for everybody. It's probably more suited to an investor that's willing to take on some incremental risk in potentially a shorter term trade idea. But then for investors who are more interested in moving up in credit, what would you recommend?

Dan Krieter:

Well, I think that the call bull market is offering pretty compelling value at the short end of the curve right now in agency and SSA space. And that's something we haven't been able to say for basically a year now when the front end of the curve just pancaked and you were picking up maybe one basis point in call bulls.

Dan Krieter:

Now that's changed after the recent sell off in the front end of the curve. And we've gotten some value back into agency and SSA call bulls which I think we should take advantage of here. And that's really being driven by a now much steeper yield curve. For example, if you look at just two year Treasury rates one year from now, they're trading at 45 basis points. And that may not sound like a lot, but when you do the math the Fed has to raise rates twice in the next three years to justify that two year, one year forward rate at 45 basis points. And I just don't think it's going to happen.

Dan Krieter:

I mean, even looking at the experience of 2008, the Fed didn't raise rates for a second time until a full eight years after rates hit zero and quantitative easing began. Now, if you compare that to this cycle, obviously rates hit zero and we restarted QE in March of 2020. So if there's going to be two rate hikes by three years from now, that would mean that the Fed accomplished that feat in half the time they did in 2008.

Dan Krieter:

And you might say everything's been much more compressed this time around. Things have happened on a much shorter timeframe in the COVID crisis compared to the financial crisis. And that's true. But let's just look at things from a tapering standpoint. Everything that the Fed has told us says that they're not going to taper until probably 2022. The most aggressive estimates might say at the end of this year, but probably 2022. So let's say the Fed starts tapering asset purchases in Q1 of 2022. The duration of tapering is likely going to be about nine months. That's how long it took the Fed to taper asset purchases at the end of QE3 last cycle.

Dan Krieter:

Now, again, things have been happening faster, but it's worth mentioning that the Fed is buying more now than it did during QE3. It's buying 120 billion now. Back then it was buying 85 billion per month. So if we say that it's the same timeframe, nine months, that is the Fed much more aggressively tapering their asset purchases going from 120 to 85. So if we say the Fed starts tapering in Q1, we have about nine months of tapering. That means that the Fed will be tapering for the majority of 2022, if not into 2023, depending on the timeline.

Dan Krieter:

Now, is there any chance the Fed's going to be raising rates before they're done tapering? I highly doubt it. And again, looking back at the financial crisis, the Fed quit tapering and then waited an entire year before raising rates the first time. So we could very easily draw a timeline where we're sitting here in March of 2023 and the Fed has not raised rates once.

Dan Krieter:

So it's very difficult to see how this two year, one year forward rate of 45 basis points on Treasuries is justified. Certainly there's a path to it, but I just argue that that path is the path to perfection and things very rarely go according to plan. And we talked about that at the top of the show. There are going to be rough patches along the way here. And I just have a really, really hard time thinking the Fed is going to get two rate hikes off for the next three years.

Dan Krieter:

And if that's the case, looking at short call bulls right now is a really compelling idea since obviously the coupon that goes into those call bulls is built off the forward curve. So the example that I've been using here in our written work is a three-year non-call one year from a tier one SSA issuer was the coupon that'll come in at about 50 basis points. For reference, that picks up 24 basis points to a duration match bullet. And to put that number in context, moving from a tier one SSA down to a double A/high single A rated corporation, picks up about 24 basis points.

Dan Krieter:

So that entire step of the credit spectrum you get in call bull premium in the SSA market with this three year non-call one year structure. And if it gets called after the one year lockout, you pick up 38 basis points to the lockout match bullet. That's a yield enhancement of over 300%, considering SSA bullets in the one year sector trading at around 12 basis points.

Dan Krieter:

And just the argument that I made about the forward curve being too aggressively priced here, if at any point in time in the next year there starts to be a greater realization that the Fed is going to be on hold longer than we might expect, those forward rates are going to prove too aggressive and the bond will be called in one year, and you'll realize that out-performance. And I really think it's a compelling idea.

Dan Krieter:

And just to finally put a bow on it, let's remember that the Fed has told us that they're going to wait longer to hike this time than they did in the previous cycle. So this comparison I was making that things needed to happen twice as fast as they did after 2008, the Feds told us they're going to wait for inflation this time. They have a higher propensity to not raise rates this time. I think I'm just harping on the same point here, so I'll wind it up. I just really think call bulls look really good right now. And it's a really compelling way to add some yield at the high end of the credit spectrum if you're a little more risk averse right now.

Dan Krieter:

Well, Dan, with those two trade ideas, I think we want to transition to maybe the focus of today's episode, which is just some pretty noteworthy developments on the SOFR front, particularly with a little bit less volatile week in credit and swap spreads during the past week. Specifically, I think there are four things we want to talk about on the SOFR front, but let's start with the most surprising announcement that we got from ARRC yesterday regarding Term SOFR.

Dan Belton:

Yeah, Dan, so yesterday the ARRC released a statement saying that they would not likely be recommending a term rate by the middle of this year as they had expected. And also they cast some doubt on the possibility that they would be recommending a term rate by the end of the year, as well. So that brings some uncertainty into the ARRC's ability to meet its stated goals through the pace transition plan, which ultimately ended with the creation of a term rate for SOFR by the end of this year.

Dan Belton:

And so this term rate, just as a background, is something that the cash markets are going to be more interested in than derivatives markets. Even if it is created and produced by the end of this year, derivative markets are likely to continue to reference overnight SOFR paid in-arrears. But cash products like loans, adjustable rate mortgages, things like that, would probably have referenced Term SOFR in an ideal world. But now guidance from the ARRC and from the Fed is likely to push these contracts to referencing overnight SOFR paid in- arrears. So it's going to be a little bit more of a process for these users to transition from LIBOR to a backwards looking overnight rate paid in-arrears. But that's probably the way that this transition is going to unfold at this point.

Dan Krieter:

I think that's the main takeaway for me here, or at least one of two. The first big one is that this is the Fed basically telling the loan side, okay, no more excuses. We've been hearing for a long time now that the loan side is waiting for Term SOFR to transition over, and that they can't really do anything until they have Term SOFR. Well, this is the ARRC telling them you might not have Term SOFR., so you better start figuring out how to compound overnight SOFR into arrears now, because that's what you're going to use. And if ultimately the Term SOFR does come, okay, then that's pretty straight forward. You can start using it then.

Dan Krieter:

But there's already some outstanding questions over, "All right, well, if I have a loan that's denominated in Term SOFR and my only option to hedge that is with a backwards looking in-arrears derivative product, then I'm going to have a basis there and who wants that basis? It's just going to be a bit of an operational headache, a lot of explanation.

Dan Krieter:

In an ideal world, you'd have the hedge and the cash market product it hedges line up. And maybe this is a step towards that. So, it's going to be interesting to see how the loan side handles this. I mean, even still now the loan side is significantly behind and it's going to be a lot of explanation that's going to need to happen. There's going to be a pretty big shift that needs to take place. But this is the Fed saying it has to happen. This is a huge year for LIBOR transition and this is really a first step. Now the loan side really has to start moving things over.

Dan Krieter:

The second big takeaway for me, Dan, was what the ARRC committee attributed this delay to. And that was the volumes in SOFR derivatives are still insufficient at this time. So even if that announcement doesn't come as a huge surprise to those of us that look at the derivative numbers, it's pretty plain to see that the Fed's move to the zero lower bound has had a significant impact on volumes. And that it was going to be a challenge to get to robustness, even if we didn't know exactly what that number is. But even still, it has to be considered at least mildly surprising, right?

Dan Belton:

Yeah. Just to put some numbers around these derivative volumes. According to the ARRC, near Term SOFR swap volumes as a percent of LIBOR total about 6% as of the most recent figures. They're about 7% of Fed funds. And then futures are about 67% of LIBOR and 46% of Fed funds. Now this liquidity deteriorates further out the curve, but it's really the near term futures and swaps that we're interested in.

Dan Belton:

So these volumes have continued to grow pretty steadily, but it's not at a level yet where the ARRC is comfortable recommending a term rate be built off of this. Now I think part of this is the ARRC is taking a conservative approach by saying they'd rather have users demonstrate capability and using the overnight rate, so that if down the road this term rate is available, then it's an easier switch to move from the overnight rate to the term rate if desired. But the overnight rate is based on deeper volumes and it's a more robust reference rate. And after all, that is the foundation of the ARRC's goal is to transition the market to a more robust reference rate.

Dan Belton:

But, Dan, I want to circle back to something you said about the ARRC statement essentially meaning that there's no more excuses for the cash market regarding SOFR adoption. And the Fed is essentially saying the same thing. We had Randal Quarles on Monday, the Fed's Vice-Chair of Supervision, saying that the United States is ready to penalize banks for ongoing LIBOR exposure. And this is just another example of something that's going to, over the longer term, help SOFR volumes and then limit some of the LIBOR exposures.

Dan Krieter:

Yeah, we've been expecting for a while now that U.S. regulators would start to be more stick and less carrot, to use a phrase here, after the carrot really failed to sufficiently mobilize the loan side away from LIBOR. Over the past couple of years they've tried to use proactive encouragement, things like that. It didn't get done. And so now the Fed and other U.S. regulators may have to go more the route that they went in Great Britain, where regulators were actively penalizing banks for LIBOR exposure. It seems that's the way we're going here to try and ultimately to get people off of LIBOR.

Dan Krieter:

And I really think this is probably just the beginning. Right now Quarles hinted at punishment for new LIBOR production after 2021. That's the starting point. And I don't think it's going to be drastic or anything, but I think the bank regulators are going to have to put in even more steps to try and get people away from the benchmark here. So this is the beginning on that.

Dan Krieter:

And I think like you said, Dan, this is going to be what ultimately gets the loan side off of LIBOR, which should start increasing natural SOFR exposure and the need for SOFR hedging of that exposure, start getting volumes up. And then at that point, maybe then the ARRC can deliver a Term SOFR rate. But in the way that the market is currently structured it's not going to happen.

Dan Krieter:

So, some interesting things there. Obviously that story is going to play out over the rest of the year to see how quickly the loan side adopts this, how seamlessly can adopt it, and to see the follow through then to volumes.

Dan Krieter:

So, two other factors we wanted to talk about. One more that's pretty related to the loan side. So why don't we just hit that one now? And that's a long-standing open question, but one of the few questions that has yet to be answered through this transition process. And that is, are we going to need a credit sensitive compliment to SOFR? And if so, what will that credit sensitive compliment be?

Dan Krieter:

I'll start by trying to answer the second question. What will that credit sensitive benchmark be if one develops? And we really, I think, and at this point we have a leader emerging. Historically it's been focused on ICE's Bank Yield Index. There's been some chatter around Ameribor. But I think that the index that Bloomberg introduced at the end of last year, the Bloomberg Short-Term Bank Yield Index, or BSBY for short, really holds the most promise.

Dan Krieter:

What the BSBY does is actually quite similar to the Bank Yield Index that ICE has proposed, but it goes a step further in terms of robustness by taking Bloomberg's unique platform that has executable quotations on it and augmenting actual transaction volume with those executable quotes. And executable quotes, really an interesting way to do that because it's probably a more reliable indicator than just quotations, since what appears on Bloomberg is executable it's where the bank is willing to raise funds. And that really might help solve the main criticism of Bank Yield Index, which is just there wasn't sufficient volume there.

Dan Krieter:

And BSBY, probably not worth getting into an in-depth detailed discussion on the methodology here on the podcast for these purposes, but I think it's just telling to say that Bloomberg is seeking independent assurance that BSBY is aligned with IOSCO's principles for what constitutes an acceptable benchmark. And I think that would really be an important step in providing a credit sensitive option, particularly as we start to engage the loan side and the broader financial system that may have a higher need for such a credit sensitive benchmark.

Dan Krieter:

The question for me is, Dan, will there need to be some sort of official endorsement or something from a regulator or some market overseer for such a rate? Or do you think that it will proliferate if demand is truly there for a credit sensitive compliment to SOFR?

Dan Belton:

Yeah, I don't think necessarily that it would require an official endorsement. It's going to, of course, depend on the amount of uptake that such a credit sensitive rate gets. But assuming that it's not something where eventually floating rate note markets and derivative markets are addressing, I think it's possible that you don't have an official endorsement from the Fed. You could see something like a third party endorse such a rate as being IOSCO compliant without really any official designation from a regulator or anything like that. But it's going to depend on just how prolific this rate becomes down the road. And that's really hard to tell at this point.

Dan Krieter:

Yeah, I agree with you. In fact, I'd be very surprised if there was any official endorsement. I highly doubt that's going to happen. We'll see if there's demand or not. But I think now we can say that there is at least a viable alternative. Whether or not it actually takes off, hard to say, but I think that Bloomberg's index here has really answered most of the key criticisms of a lot of candidates for a credit sensitive compliment to SOFR. And now we'll just see if the demand is there. So that's something we'll be keeping an eye on as well, as the transition away from LIBOR really starts to permeate the loan side through 2021.

Dan Krieter:

Now quickly then, before we wrap up, I thought it'd be helpful to provide a quick update on what's happening in the SOFR FRN market.

Dan Belton:

Yeah, Dan, SOFR FRN supply has fallen fairly substantially this year. Year to date, we've had just about 72 billion in supply. And that's down from last year when we were seeing 40 to 50 billion in a good month in the second half of the year. And of course, back in March at the onset of the pandemic we saw about 150 billion in SOFR FRN supply.

Dan Belton:

So a fairly sizeable step back year-to-date, and this is largely due to the fall in SOFR. SOFR, obviously, is a repo rate. Repo has been trading extremely low most of this year. The past couple of weeks SOFR has printed at just one basis point. So that's just a less attractive rate from the standpoint of an investor.

Dan Belton:

But then a couple of encouraging developments with respect to this market this year. First, we've had the introduction of non-financial corporate borrowers in the SOFR FRN market. We had the first one in February, and since then there's been about five or six more SOFR FRN issues from non-financial corporates. And that's something that we're going to expect to see increasingly common.

Dan Belton:

And then the market has become slightly less reliant on the GSEs. So GSEs typically make up the vast majority of SOFR FRN issuance, totaling about 80 to 85% of the overall market. They've actually been outpaced year-to-date by financial borrowers. So that's an encouraging development just as the breadth of issuance increases in this market, and we have more and more different types of borrowers tapping this SOFR FRN market.

Dan Belton:

Dan, anything else we need to touch on with the SOFR or LIBOR transition?

Dan Krieter:

No, I think that pretty much covers it. Anything we didn't cover here or any other questions you have, please don't hesitate to reach out. We're happy to answer them. Otherwise, we'll be back next week. Thanks for listening.

Dan Belton:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/ macrohorizons. As we aspire to keep our strategy efforts as interactive as possible, we'd love to hear what you thought of today's episode. Please email us at daniel.belton, B-E-L-T-O-N, @bmo.com. You can listen to this show and subscribe on Apple podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's marketing team. The show has been edited and produced by Puddle Creative.

Disclosure:

This podcast has been prepared with the assistance of employees at Bank of Montreal, BMO Nesbitt Burns Incorporated, and BMO Capital Markets Corporation (together, "BMO") who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally, and not a research report that reflects the views of disinterested research analysts.

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Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment for strategy referenced herein may be suitable for you.

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It does not take into account the particular investment objectives, financial conditions, or needs of individual clients. Nothing in this podcast constitutes investment, legal, accounting, or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances, or otherwise constitutes an opinion or a recommendation to you.

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BMO is not undertaking to act as a swap advisor to you or in your best interests and you, to the extent applicable, will rely solely on advice from your qualified independent representative in making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters referred to herein together with your qualified independent representative, if applicable.

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BMO assumes no obligation to correct or update this podcast. This podcast does not contain all information that may be required to evaluate any transaction or matter. And information may be available to BMO and/or its affiliates that is not reflected herein. BMO and its affiliates may have positions, long or short, and effect transactions or make markets, in securities mentioned herein, or provide advice or loans to, or participate in the underwriting or restructuring of the obligations of issuers and companies mentioned herein. Moreover, BMO's trading desks may have acted on the basis of the information in this podcast. For further information, please go to bmocm.com/macrohorizons/legal.

 

Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD



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