With the cessation date of the remaining USD LIBOR (London Interbank Offered Rate) settings a year away, it is surprising to see how much work is yet to be done and how different market players are reacting to USD LIBOR and its successor, the Secured Overnight Financing Rate (SOFR). While industry participants push for the development of a SOFR-linked derivatives market, the bond market is discussed less frequently. However, debt issuance is also a critical market indicator when evaluating a benchmark rate like SOFR.
For the analysis shown here, we collected new debt issuance data from January 2019 to January 2022, compiled by issuer type, coupon structure, and maturity term:
- Issuer types: corporate, agency, and sovereign
- Coupon structures: fixed rate and floating rate (LIBOR, SOFR, Term SOFR, SOFR Average, other alternative rates (effective federal funds rate (EFFR), Bloomberg Short Term Bank Yield Index (BSBY), American Interbank Offered Rate (AMERIBOR)), and stepped coupon)
- Maturity terms by years to maturity (YTM): short term (0-2), medium term (2-5), and long term (5+)
The data indicates that SOFR debt issues are increasing, especially since mid-2021, thanks to the SOFR First initiative. However, the new issues show a different landscape from the LIBOR ones, which may imply the future of the SOFR bond market.
Corporate Issuers Hesitate to Expand Maturity Depth of SOFR FRN
We’re seeing a slow transition of new corporate issuance away from LIBOR and proactive activity in various alternative rates. Total issues and floating rate note (FRN) issues have remained steady in recent years; SOFR issues in 2021 are about 8% more than LIBOR issues in 2019 in terms of issue amounts. That said, corporate issuers are actively exploring different reference rate types when issuing FRNs. Those alternative reference rates are usually set in advance, compared with the set-in-arrears SOFR. As shown in Figure 1, Term SOFR issues represent approximately 7% of the total FRN issues each year. The issue amounts of FRNs referencing other alternative rates were $1-2 billion in 2020 and 2021, respectively.
As shown in Figure 2, each maturity term represents an equal share of total issues in the LIBOR case. On the contrary, new SOFR issues appear to be mostly short term. Long-term SOFR issues represent about 19% of the total, yet most of them mature in less than 10 years. There have been requests for a set-in-advance SOFR-based index since the early stage of the transition away from LIBOR. One of the obvious reasons for this is that market participants have grown accustomed to the set-in-advance LIBOR in terms of technology, operations, and trade. Apart from the appeal of setting in advance, there are several explanations for the issuance landscape:
- Issuers are not motivated to issue longer-tenor bonds. With the current state of the economy and rising inflation, it is riskier to launch longer-tenor bond deals as investors demand higher yields when inflation is increasing. However, Figure 3 shows that the yield of longer-maturity bonds is much less sensitive than the yield of short-maturity bonds. Additionally, a Federal Reserve tightening policy could lead to an inverted yield curve. Figure 4 suggests that U.S. treasury curves have started to slope downward on the long end since January 2022.
- The availability of other alternative rates expands options on debt issuance, while casting uncertainty on the benchmark rate in the long run. Besides the more popular derivative-derived Term SOFR and SOFR Average calculated on historical rates, there are EFFR, BSBY, and AMERIBOR with about $1.3 billion in mid-to-long-term bonds issued in 2021. The issue amount is far less than that of SOFR, but the trend has been to issue longer maturity bonds linked to Term SOFR.
- There is still a long way to go before reaching a liquid SOFR market. The use of SOFR in interest rate swaps has been increasing over the last year with broad offerings on maturity terms from months to 30+ years, but we do not see the same maturity depth in bond offerings. This is interesting as the interest rate swaps are often used as a hedging tool against the risk exposure in bonds. The lack of liquidity in the long-term bond market cannot provide for a meaningful SOFR bond yield curve and term premiums, further discouraging issuers and investors from entering the market.
As a result, Term SOFR fills the need of long-term bonds to some degree. However, Term SOFR will not be a perfect supplement to the SOFR bond maturity spectrum. As we’ve previously discussed, paradoxes arise as market participants aim to develop both SOFR and Term SOFR in cash and derivatives markets.
Agency Issuers Moving Away from LIBOR
Agency issuers tapped into SOFR debts as early as 2019, and the issue amount peaked in 2020. SOFR issues fell in 2021, along with the overall size of FRN issuance.
LIBOR issues have effectively fallen to zero since 2019, indicating that U.S. agencies are leading the transition movement. However, the willingness to issue SOFR debts has weakened, even with a relative surge in issuing stepped coupons and other alternative rates. The lack of clarity on Term SOFR has led to hesitation on SOFR issues. One thing that a stepped coupon bond and a LIBOR bond share is that the coupon rate is set in advance. The stepped coupon is the only coupon type that shows an increase in issue amount, while total FRN issue amounts decreased by about 70% from 2020 to 2021. With Term SOFR unveiled and officially endorsed in late 2021, we’ll keep watching the agency issuance for 2022—this may become a competition between SOFR and Term SOFR.
Sovereign Issuers Aloof Toward SOFR Issuance
Sovereign issuers are clearly hesitant about referencing SOFR. Total SOFR issuance from 2019 to January 2022 was just $0.5 billion, compared with LIBOR issuance of around $4 billion. With LIBOR issues coming to an end, there has been an increase in stepped-coupon issues, but it is hard to conclude whether there is any direct connection between the two. There is an argument that sovereign, supranational, and agency (SSA) issuers are the best candidates to lead in SOFR bond maturity offerings. The World Bank and other agencies have launched billions of seven-year SOFR bonds in the past few months, which should get the ball rolling.
Global View: SONIA Doing Well But TONAR Struggling
As all tenor settings of GBP and JPY LIBOR have ceased as of December 31, 2021, the Sterling Overnight Index Average (SONIA) and Tokyo Overnight Average Rate (TONAR) bond markets can serve as good indicators of the future of the SOFR bond market.
The UK bond market is smaller than the U.S. market. The UK corporate issue amount is about 8% of its U.S. counterpart, while the SSA issue amounts are even less than 8%. The UK SSA issuers are not enthusiastic about FRN issuance, let alone SONIA issuance. Corporate SONIA issuance appears to be more organic:
- The SONIA issue amount in 2021 is equivalent in scale to the LIBOR issue amount in 2019, implying an effective transition
- Each maturity term takes an equal share in the SONIA issuance, suggesting a deep maturity tenor offering
- SONIA appears to be strongly advocated as a benchmark rate with minimal Term SONIA issuance and no other alternative rates in consideration
The Japanese bond market is more relatable to the U.S. market in terms of issue amounts. There are several reference rates in Japan that have been gaining popularity since the transition away from LIBOR, including the Tokyo Interbank Offered Rate (TIBOR), Tokyo Term Risk Free Rate (TORF), and treasury rates. As in the UK, SSA issuers in Japan are not interested in FRN issuance. As for corporate issuance, we have observed the following trends:
- The transition is happening very slowly. Approximately 18% of FRN issued in 2021 referenced LIBOR. According to the recommended fallback waterfall from the Bank of Japan, the first level will convert LIBOR to TORF.
- There seems to be no motivation to issue TONAR debt. There is a $1 billion bond issuance on TONAR in 2019, followed by zero in 2020. In 2021, there was a one-time TONAR bond issuance by Mitsubishi Corporation of $130 billion, amounting to about 3% of FRN issuance.
- TIBOR maintains its popularity while treasury rates are on the rise. The TIBOR issuance has been steady at around 5% of FRN issuance each year. However, the treasury linked issuance represented approximately 6% of FRN issuance in 2020 and rapidly increased to 53% in 2021. In January 2022 alone, the treasury-linked issue amount was $95 billion compared with zero TONAR issues.
The U.S. bond market seems to fall between the UK and Japan markets. The U.S. market is picking up on SOFR issuance, but lacking maturity depth as seen in the UK market. There are several alternative rates gaining popularity, but nothing comes out as strong as TIBOR or treasury rates in the Japan market.
As Rome wasn’t built in a day, several milestones have been hit in the development of the SOFR bond market, but this might be the beginning of the journey. As much as we would love to see a deeper SOFR bond market, the development might not follow the path of LIBOR. With Term SOFR and the other alternative rates actively being used, the future of the FRN bond market could be more diversified yet more complicated in many ways.
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