The End of LIBOR: Hotel California Edition [Part IV]

Below is a brief analysis.

What Is in a Name

In the United States, the deadline for the transitioning of LIBOR facilities to SOFR was June 30, 2023 (though delayed for securitizations and multi-lender facilities through the use of “Zombie” LIBOR until September 30, 2024).

But there are a number of distinct permutations of SOFR with discrete transition ramifications which had previously been highlighted in Part I of this Hotel California Series:

• Term SOFR
  • Calculated by CME Group.
  • Determined on the futures market.
  • Is not an actual interest rate.
  • Is a credit-sensitive benchmark like LIBOR.
  • Favored by lenders (and is used in most loan/bond transactions).
• Daily Simple SOFR
  • Calculated by the New York Fed.
  • Is an actual interest rate.
  • Is a “risk-free” benchmark (to the extent possible under current conditions).
  • Favored by regulators and used in most swap transactions.
• 30-Day Average SOFR
  • Calculated by the New York Fed.
  • Is an historical average of Daily Simple SOFR.
  • Consequently, is a “risk-free” benchmark (to the extent possible under current conditions).
  • Had been favored by this author since:
    • Calculated by the New York Fed.
    • An actual interest rate.
    • Most resembled One-Month LIBOR (without many of the attendant risks).

It should be noted that LIBOR is the subject of two UK Supreme Court cases heard in late March 2025 to determine LIBOR’s definition as reported in Part II of this Hotel California Series. This three-day hearing took place nearly 13 years after the LIBOR scandal first erupted in public.

Expected Financial Benefits/Costs

“Naked” Bonds and Loans

As highlighted in Part III of this Hotel California Series, from February 2022 through July 2023, based upon frequent tracking, Term SOFR was never beneficial to borrowers assuming there was no related swap with a previously locked-in interest rate.

However, from August 2023 to the present, Term SOFR versus 30-Day Average SOFR (and Daily Simple SOFR) was generally favorable or least neutral to borrowers to the extent there was not a related swap.

Interest Rate Swaps

The following discussion relates to loans and bonds where there is an associated swap.

Best Hedging Practice

Under typical circumstances, a financing would be based upon Term SOFR and the related swap would be based upon Daily Simple SOFR, thereby potentially negating the benefits of a hedge, especially if there are market dislocations.

To better hedge, we had repeatedly suggested that the benchmarks utilized for loans/bonds be the same benchmark utilized in the related interest rate swaps – 30-Day Average SOFR (regulators have insisted that Term SOFR not be used for swaps). However, there was often lender/swap counterparty resistance, or the terms of the loans/bonds and related swaps had already been pre-negotiated prior to our involvement.

Corporates

Not considering the numerous risks associated with entering interest rate swaps, such as basis, tenor, termination, and bank counterparty risks, there was a financial benefit since July 25, 2024, to enter into a swap. This is reflected by the tracking of 10-Year Treasury rates versus the 10-Year SOFR swap rates on a weekly basis.

In this timeframe, the swap rate was generally lower than the Treasury rate by an approximate average of 35 basis points. Consequently, a swap in the corporate context may have made financial sense from a borrower’s standpoint during this period.

Municipals

Though this financial benefit is applicable in the corporate context, this does not appear to be the case for municipals. This is based upon a general analysis since July 2024, that compares 10-Year Bloomberg’s Evaluated Pricing Service municipal rates to 10-Year Securities Industry and Financial Markets Association rates on a weekly basis.

In this timeframe, the swap rate was generally higher than the municipal rate by an approximate average of 13 basis points. Consequently, a swap in the municipal context did not generally make financial sense from a borrower’s standpoint, with significant fluctuations dependent upon when the swap rate was determined. If, instead, 80% of 10-Year Treasury rates or 10-year SOFR swap rates are used, the utility of a swap was generally even worse from a borrower’s perspective during this period.

Historical Outliers

In regularly tracking Term SOFR and Daily Simple SOFR, for almost three years as part of the LIBOR transition, had the following weeks as outliers. Meaning there were differential changes in Term SOFR that equaled or exceeded 10 basis points as compared to the changes in Daily Simple SOFR[1] for that same week from the previous week.

Analysis

This is particularly important since, based upon our experience, most loans/bonds utilize Term SOFR while related interest rate swaps use Daily Simple SOFR as the benchmark. It should be noted that the methodology for calculating Daily Simple SOFR (and 30-Day Average SOFR) was changed by the New York Fed on November 24, 2024, to make it more objective. Presumably, this impacts the Term SOFR benchmark as well.

Recent Regulator Changes and Statements

Regulators have made the following statements and taken the following actions, (1) Term SOFR, since it is not a risk-free benchmark and is subject to some of the similar concerns of LIBOR, should be utilized in limited circumstances for loans/bonds (which generally is not the case for borrowers), (2) for swaps, Daily Simple SOFR is the preferred benchmark for swaps (which generally is the case), and (3) due to refinements, the methodology of calculating Daily Simple SOFR (and 30-Day Average SOFR) was modified in November 2024 by the New York Fed as previously mentioned.

Summary

In conclusion:

• SOFR could mean Term SOFR, Daily Simple SOFR, and/or 30-Day Average SOFR.
• Mixing these concepts in the same financing could be detrimental.
• There have been historical unexplained differentials among benchmarks.
• Regulators are not keen on the use of Term SOFR though most frequently utilized on loans and bonds for borrowers.
• Hedges in the municipal bond context have not recently been beneficial to borrowers.

Mirrors on the ceiling,
The pink champagne on ice
And she said, ‘We are all just prisoners here,
of our own device’

– Eagles, “Hotel California”