Term SOFR Hedges: The Price of Perfection

What Is Basis Risk and Where Does It Come From?

Basis risk arises where there is a potential mismatch between a position and its hedge. Loans now generally bear interest at CME Term SOFR, which is calculated at the beginning of an interest period. Typical interest rate swaps used to hedge floating loan rates settle based on SOFR in arrears, which is determined by daily compounding in arrears and is not fully computed until the end of the interest period. Because of the potential mismatch between term SOFR and SOFR in arrears, the borrower assumes a certain amount of basis risk.

Term SOFR, as used in loans, is a rate that is set based on closing prices of the Chicago Mercantile Exchange’s term SOFR contract. Those prices are based on the market’s estimate of what SOFR will be at the end of the next 30- or 90-day period. Term SOFR is forward-looking and is set at the beginning of the interest rate calculation period. SOFR in arrears, as used in swap and option transactions, is based on an average compounded rate of actual prices over the past 30 or 90 days. In-arrears SOFR is backward-looking and is set towards the end of the interest rate calculation period.

The estimated term rate may be either higher or lower than the historical rate that is calculated in arrears. If the borrower pays the term rate to the lender and receives the historical rate from the swap counterparty, the borrower takes the risk that the historically calculated rate will be lower than the term rate. If this happens, the swap settlement will be insufficient to cover the full interest payment on the loan and the borrower will need to supplement the amount received from its swap dealer in order to meet its loan obligations. Of course, if the SOFR in-arrears rate turns out to be greater than the term SOFR rate, the borrower receives a windfall.

This leads to four questions: how did we arrive here; can the derivative be settled on a term basis; how can we estimate the basis risk; and how much will it cost for a term SOFR swap?

How Did We Get Here?

The transition from LIBOR to SOFR was intended to address perceived widespread manipulation of LIBOR, largely in the derivatives markets. The transition was managed by the Alternative Reference Rate Committee (ARRC), which was composed of various banks and closely coordinated with the Federal Reserve and industry groups. The prevailing sentiment at the ARRC was that SOFR was less susceptible to manipulation than LIBOR because SOFR was based on actual Treasury repurchase transactions while LIBOR was based on dealer estimates. Since term SOFR is an estimate of what the SOFR rate should be in the future, the ARRC was hesitant to support the broad use of term SOFR. However, since the borrowing market very much appreciated the certainty that term SOFR offered by allowing borrowers to know their interest payment at the beginning of an interest accrual period, rather than at the end, the ARRC compromised and condoned limited use of term SOFR with respect to debt.

Can Swaps and Options Be Settled Based on Term SOFR?

That compromise from the ARRC included allowing swap dealers’ use of term SOFR to settle swaps and options, but only to the extent that the counterparty is a non-dealer. Effectively, there is a prohibition on dealer-to-dealer trades of term SOFR. As a result, when dealers offer term SOFR swaps to their borrowers, the dealers would assume the basis risk between the in-arrears SOFR products that they could trade freely with other dealers and the term SOFR products that they execute with borrowers. Because each term SOFR derivative may result in the assumption of basis risk by the dealer, dealers sometimes charge a premium for that assumption of risk that may not be specifically identified but results in either a higher fixed amount payable by the borrower under the swap or a lower floating amount payable by the dealer.

On the other hand, a bank’s receipt of term SOFR from interest payments on loans may help to offset the bank’s basis risk from term SOFR swaps. That, however, would require a greater degree of inter-divisional balance sheet coordination that many banks may find difficult.

Roughly, How Much Risk Is There Between a One-Month Term SOFR Swap and a One-Month Historical 30-Day SOFR Swap?

Differences in the forward-looking and in-arrears rates could occur as a result of unexpected occurrences in the actual market that were not foreseen in the market when the term SOFR rate was set at the beginning of a rate period. For example, if there were a drastic spike in the SOFR rate during a rate period, the SOFR in-arrears calculation would be higher at the end of the period than the term SOFR rate that was set at the beginning of the period. Alternatively, if the Federal Reserve were to unexpectedly lower rates, the SOFR in-arrears rate would be lower than the term SOFR rate. Typically, the term SOFR rate and the SOFR in-arrears rate align and the effect of unforeseen events is muted by the averaging feature used for SOFR in arrears.

As of May 1, 2023, the CME term SOFR rate was set at 5.03387% and on May 30, 2023 the Federal Reserve Bank of New York historical 30-day average SOFR rate was 5.03215%. The difference between the two rates was .00172%. Research indicates that over a four-year period, the difference between one-month term SOFR and in-arrears SOFR (30-day realized average) was about two or three basis points with a few notable outlying instances where the difference was as great as 90 basis points.

How Much Will It Cost for a Term SOFR Swap?

In theory, the cost of a term SOFR swap versus an in-arrears SOFR swap should represent the basis risk described above. However, dealers may ask for a premium over the basis risk because they may have a buildup of basis risk, or a limited supply of offsetting term SOFR loan revenue. The amount of the premium represents the difference between the fixed rate paid for a 30-day historical SOFR swap and the fixed rate paid for an otherwise comparable one-month term SOFR swap. The premium may not be apparent to a borrower because it is blended into the other costs, charges and expenses in the dealer’s pre-trade mid-market mark.

As an aid to transparency, CFTC Rule 23.431 requires swap dealers, prior to entering into a swap, to provide the counterparty with material information reasonably designed to allow the counterparty to assess the material conflicts of interest and incentives that the swap dealer may have. Such disclosures include the price of the swap and the mid-market mark of the swap. The difference between the fixed price and the mid-market mark would include profit, credit reserve, hedging, funding, liquidity and other costs or adjustments and should include term SOFR basis risk premium. We encourage clients to ask for the pre-trade mid-market mark as an aid in understanding costs.

Swap advisors are reporting that the premium may currently range from 3 to 7 basis points. We have seen requests for premium as high as 15 basis points, and some institutions claim not to be charging any premium at all. In short, the amount of premium is difficult to ascertain but should be apparent when comparing pricing between a term SOFR swap and a SOFR in-arrears swap.

If a dealer is willing to offer a term SOFR swap to hedge a term SOFR loan, the borrower should make sure that it understands the pricing methodology, then determine whether it is worth it to pay any imbedded premium to align the swap rate with the loan to shift basis risk to the dealer.

In order to monetize the basis point value, swap advisors will use a dollar value calculation. In particular, DV01 measures the exposure of the swap position to a move of one percentage point in the forward market. As an example, assume that the fixed rate on a term SOFR swap is five basis points higher than the fixed rate on a SOFR in-arrears swap with all other terms being equal. That five basis points, when calculated as DV01, represents the cost of the better hedge. DV01 is dependent on notional amount and other variables and can be calculated by a swap advisor.

Summary

For policy reasons that limit the ability of swap dealers to hedge their term SOFR risk with other dealers, a swap dealer may be exposed to basis risk in its term SOFR portfolio that can be hedged only by SOFR in arrears. Accordingly, a dealer may charge borrowers a premium to compensate the dealer for assuming the basis risk. Whether that premium is worthwhile will depend on the borrower’s appetite for risk and the cost of the premium. Is the borrower comfortable with two basis points of basis risk? Is an extra four or five basis points worth it to avoid the borrower’s basis risk? In this regard, the services of a qualified and experienced swap advisor may be worthwhile. The borrower of a term SOFR loan would want to know:

• Whether the swap dealer would be willing to offer a term SOFR swap so that the swap is aligned with the loan (and the dealer would assume all basis risk).
• If the loan bears interest calculated by reference to term SOFR and the borrower hedges its variable interest rate exposure with a SOFR in-arrears swap rate, how much estimated basis risk is the borrower exposed to?
• How much more will the fixed rate be for an identical swap that uses term SOFR as the floating rate rather than SOFR in-arrears?
• What is the dollar value of any premium that the dealer is charging for the term SOFR swap?

Ballard Spahr is a national law firm that frequently represents clients in connection with hedging transactions and works closely with clients and their swap advisors to understand and address the economic impact of each transaction. Ballard Spahr’s Derivatives, Structured Products and Secondary Markets team is co-managed by Scott Diamond and Joyce Gorman, who also co-manage the Investment Banking and Capital Markets team of the firm’s Banking and Financial Services group, and also are members of the Public Finance Practice.

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