FEATURE
Libor part 3 - Backwards and forwards Sofr has overcome early resistance to become the dominant index for new trading and lending transactions, including structured products.
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owever, replacing USD Libor with Sofr does not amend or modify a contract while concerns remain on ‘diverging protocols’. In the last of a three-part article, we look at potential upcoming liquidity issues to hedge derivatives, issues with the transition for some payoff types and legacy notes.
Private Bank in Singapore is also concerned about diverging protocols for more exotic rates-linked structured notes such as Libor range accruals and steepeners. These payoff types have been marked as problematic throughout the transition process, since the economics of the payoff changes when upfront fixing becomes fixing in-arrears.
Because the ‘official sector’ discourages term Sofr except where Sofr in arrears has proven difficult, new US jurisdiction structured notes reference Sofr in arrears.
The SRP databases list 539 USD Libor-linked range products still to remediate, with a sales volume of over US$4 billion, and a smaller cache of 35 steepener products worth US$310m.
However, market players fear the hedging implications of an emerging rate bifurcation between European or London loan markets and their US counterparts. While London-based Loan Market Association (LMA) documentation has so far transitioned on the basis of compounded rates in arrears the US loan market seems to be settling at term Sofra. CME Group's Term Sofr, which prices off Sofr futures markets, has been officially endorsed since an Alternative Reference Rates Committee (ARRC) announcement on 29 July 2021 last year. A lawyer who prefers not to be named asks what that might mean for hedging with derivatives. “Will the liquidity pool be as great if split between Sofra compounded in arrears and term Sofra? This absolutely touches structured products as well, since they sit somewhere between derivatives and bonds.” Ling Chih Chang, senior fixed income product manager at DBS
The Libor portion of such US jurisdiction products is covered by AIRLA. Take the latest scheduled maturity, for example, an advised Harris Bank income product sold in the US and linked to the USD three-month Libor and the S&P 500. This Callable Dual Range Accrual CD - S&P 500, USD 3M Libor (05600XAF7) is capital protected and pays a 3% pa monthly coupon for the first four years of investment, then a monthly coupon at 3% pa pro rata for the number of days three-month US dollar Libor is 0.10% or higher, and the equity index is 75% or more of its initial level. The issuer can terminate the product monthly after the first year of investment. Otherwise, it repays capital and any final coupon on maturity in 2040. Ten years behind in maturity terms is a callable Korean capital-protected income range accrual product distributed by Shinhan Investment. Shinhan DLB 249 pays a variable coupon of 4% pa pro rata for the number of days the 10-year USD CMS
Investors should continue to emphasize liquidity over ease-of-use in their choice of benchmarks Ling Chih Chang, DBS Private Bank
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