Recommended Benchmarks or Credit-Sensitive Indices: The Best Path Forward?

The best benchmark for a company or a bank primarily depends upon the entity’s debt/interest rate swap situation as summarized below. This analysis also touches on the rationale behind the derivatives market’s recent embrace of the move to recommended benchmarks in the US, starting on July 26.

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General

In the US, SOFR is the recommended benchmark but has not been widely adopted. In the UK, SONIA is the recommended benchmark and has been widely adopted.

Which is better to utilize primarily depends upon the company’s and the bank’s combined debt and interest rate swap situation.

Recommended Benchmarks

Enumerated below are the positive and negative attributes of utilizing recommended benchmarks:

Positive

  • More likely to be stable upon market disruptions (e.g. March 2020 pandemic) though significant unexplained disruptions in SOFR in September 2019
  • Objectively established rate

Negative

  • Newly developed benchmark with limited track record (as compared to LIBOR)
  • SOFR not widely adopted by banks in the US

Credit-Sensitive Indices

Enumerated below are the positive and negative attributes of utilizing credit-sensitive benchmarks:

Positive

  • Attempts to replicate LIBOR’s credit-sensitive nature unlike SOFR
  • Less likely to be manipulated than LIBOR

Negative

  • More likely to be impacted upon market disruptions
  • Even more limited track record than SOFR

Best Index to Use – It Depends

The use of recommended benchmarks versus credit-sensitive indices depends upon the overall debt situation, in particular the use of interest rate swaps, for each type of entity as generally summarized below:

Companies

LIBOR-Based Loans/Limited Swap Exposure

For these types of companies with limited interest rate swap exposure, lower and more stable interest rates are preferred.

Answer: Recommended Benchmarks

LIBOR-Based Loans/Extensive Swap Exposure

With those companies having significant variable rate debt that is covered by interest rate swaps, these companies (counterintuitively) want higher interest rates. Higher interest rates reduce/eliminate the negative mark-to-market value of swaps to companies.

It should be noted that if the bank counterparty continues to pay the variable rate due under the interest rate swaps, these companies continue to pay the fixed rate due under the swaps. Consequently, higher interest rates do not impact the company’s debt obligations though, as mentioned above, favorably impact swap liabilities.

Answer: Credit-Sensitive Indices

Banks

LIBOR-Based Loans/Limited Swap Exposure

For these types of banks with limited interest rate swap exposure, higher interest rates from borrowers are preferred.

Answer: Credit-Sensitive Indices

LIBOR-Based Loans/Extensive Swap Exposure

With those banks having a significant amount of interest rate swaps, such as the largest international banks, these banks (counterintuitively) want lower interest rates. Lower interest rates increase the mark-to-market value of swaps to bank counterparties (and, in a parallel fashion, as mentioned above, increases the negative mark-to-market value to the company counterparty).

Answer: Recommended Benchmarks

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