Demand for SOFR-based muni debt has been slow to emerge

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WASHINGTON – Buy-side demand for floating rate debt using the Secured Overnight Financing Rate known as SOFR been slow to emerge in the municipal bond market as the industry moves toward a 2022 deadline.

There have been no publicly announced municipal debt offerings so far in 2019 that have used SOFR and there were only three in 2018. Two of those were issued by the New York Metropolitan Transportation Authority. Experts blamed an apparent lack of demand for the slow shift to SOFR-based deals despite the increasing urgency to move away from debt pegged to the London inter-bank Offered Rate, commonly referred to as Libor.

“The MTA is a large transactional debt issuer and the timing was right in September 2018,” said Emily Brock, director of the federal liaison center for the Government Finance Officers Association. “There were several corporate transactions that happened just prior to the MTA making the decision to transition to SOFR.”

Brock couldn’t predict when other SOFR-based deals will be issued. “I think people are very positive that there is something to look at,” she said.

Libor is being phased out at the end of 2021 at the recommendation of the Alternative Rates Reference Committee which was created by the U.S. Federal Reserve Board and the Federal Reserve Bank of New York. The Financial Conduct Authority in London announced in 2017 that it would abandon Libor.

SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Federal Reserve Vice Chairman Randal Quarles has said SOFR “reflects the largest and deepest rates market in the world” and its creation “is a huge accomplishment.”

Federal Reserve officials have advised municipal issuers to begin using SOFR-based floating rate debt in their new issuances rather than facing the uncertainties of converting new Libor-based debt at a later date.

“I think the problem is trying to find buyers who will buy SOFR-based deals,” said Nathaniel Singer, senior managing director of SWAP Financial Group. “The buyers are trying to get their arms around what SOFR is, how it’s going to react in the future.”

SOFR is a lower number than LIBOR because it’s an overnight rate rather a 30-day or 90-day rate and because it’s a secured rate rather than an unsecured rate it produces less yield, Singer said.

“Like any new product in the market, the buyers not only want a spread adjustment to make them whole, they probably want a little bit more to compensate for the newness or the illiquidity of the product,” Singer added.

Issuers “would love to” use SOFR, according to Singer. “It’s just the demand side isn’t there yet.”

Even in the taxable market, there have only been about $42 billion in issuances led by government-sponsored institutions such as the World Bank and Fannie Mae that are doing their part to prime the market, Singer said. “IBM’s not going to do it if it costs them money,” he said. “General Electric’s not going to do it if it costs them money.”

Michael Decker, managing director and co-head of municipal securities at the Securities Industry and Financial Markets Association, said SOFR remains “a new product and it’s not been widely adopted in any market sector yet.”

“In the corporate and taxable markets there have been a handful of deals,” Decker said. “I think it will just take time. It’ll take socializing the index. It’ll take people educating themselves and getting comfortable about how it behaves under different circumstances, being able to model the expected performance of the index over time.”

Floating rate debt is only a small fraction of the municipal bond market.

The Securities Industry and Financial Markets Association listed $76.9 billion in publicly issued municipal bonds from 872 issuances that used floating rate debt as of Dec. 18, 2018. That’s only 2% of the $3.8 trillion municipal bond market and includes debt that uses the SIFMA index but doesn’t include swaps.

Libor based municipal debt was an even smaller amount at $47.6 billion or about 1.3% of the overall muni market.

In the bigger picture, the Federal Reserve estimated last year there were roughly $200 trillion of financial securities referencing U.S. dollar Libor.

Conversion of that Libor-based municipal debt to SOFR-based debt has yet to emerge in trading.

“We are monitoring this,” said Seema Mohanty, managing director of the municipal advisor Mohanty Gargiulo in Manhattan. “As more developments come, we are looking for our clients on what kind of conversions we should be doing.”

Treasury and the IRS officials are working on proposed regulations to allow issuers to avert a reissuance if they convert their debt or swaps out of Libor and into SOFR. The proposal would be subject to public comment under Section 1001 of the Internal Revenue Code and include arbitrage rules on swaps for munis.

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