• BSBY, the Bloomberg Short Term Bond Yield Index, which once was a contender to replace LIBOR, will cease to exist on November 15, 2024. If you’ve never heard of BSBY, or know of its existence only dimly, that is no surprise. It was once touted as a replacement for LIBOR (The London Interbank Offered Rate) which was the standard index to which interest rates on floating rate securities were tied from the early 1970s until it was discontinued on June 30, 2023 (See Beyond the News The End of LIBOR here).  But it was bested by SOFR—the Secured Overnight Financing Rate—heavily favored by financial market regulators.

• SOFR provides great accuracy in representing short-term market rates, but it exposes investors to credit risk during periods of market stress. BSBY was an alternative designed to maintain the credit risk “hot potato” in the hands of issuers of securities as it was with LIBOR.
• The failure of BSBY to catch-on, or more precisely the push by regulators for SOFR instead, means public funds investors should be more cautious in using floating rate securities linked to this index in their portfolios, as they will be directly in the line of fire when credit markets deteriorate.

The details. After the Great Recession regulators determined to replace LIBOR as the dominant index to link floating rate securities. LIBOR was meant to represent the rate on unsecured obligations (commercial paper, corporate notes, bank loans, etc.)   It had grown over its 40-year life to be the dominant market index, and as such had great depth and liquidity—meaning that issuers, dealers, and holders could easily exchange value around it. But it   was criticized because of the lack of transparency around the daily rate setting. This was done by “agreement” among 17 global banks, but market behavior around the time of the Great Recession revealed evidence of manipulation. So, it had to go.

SOFR and BSBY emerged as two alternatives. Among the differences:  SOFR was meant to represent the rate on secured obligations, while BSBY was meant to measure value for unsecured obligations. This may not seem like an important distinction, but it can be during times of market stress because it determines whether it is issuers or holders of obligations that bear the risk of credit market distortions.

SOFR is determined by the Federal Reserve Bank of New York based on actual repo transactions in the $1.8 trillion overnight market. So far, so good. But these are unsecured transactions. This means that holders of SOFR-based instruments are vulnerable to increased price volatility in times of market stress.

Normally rates on secured and unsecured transactions move in tandem and in close correlation with the Federal Reserve’s policy rate. (See the above chart.) Rates on unsecured transactions would be expected to be set somewhat higher than those on secured transactions but this spread is fairly stable, representing the added risk and lower liquidity of credit-backed instruments when compared with comparable-maturity risk-free (secured) obligations.  A look back at the spread between the two over the past five years shows the difference to average  about ten basis points.

There are times, however, when this spread can widen precipitously. During the Covid lockdowns spreads widened to nearly 100 basis points, as credit markets generally were stressed.  This widening pushed the value of fixed rate credit instruments (CP, negotiable CDs, corporate bonds) lower when compared with risk-free investments (Treasuries) of comparable maturity.

This loss of value was buffered for floating rate securities whose interest rates were tied to LIBOR because the LIBOR spread moved wider as well, requiring issuers to pay more intertest to offset the rise in credit market risk. Had these securities been linked to SOFR instead, the cost of this widening would have been reflected in the value of these securities.

Longer-maturity securities would have suffered from more price depreciation. The below chart quantifies the effect of a 100 basis point change in spread on a floating rate security that resets value based on SOFR.

[Footnote:  during the COVID-related market disruption this loss was somewhat obscured by the fact that the Federal Reserve intervened to push short term rates lower by 200 basis points.]

BSBY represented an alternative reference rate that would have protected investors in floating rate securities from bearing the cost of these credit market events. But the Federal regulators gave it a thumbs-down. To them, the protection was less important than the market transparency gained by linking the preferred index (SOFR) to the $1.8 trillion repo market.

So be it. But, as the International Organization of Securities Commissioners warned, in carefully crafted language designed so as not to contradict the US regulators, the new standard has “varying degrees of vulnerabilities” during times of market stress.

The bottom line. Buyer (or holder) beware. SOFR-linked obligations are not without market-related risk. Rigorous stress testing focused on the life of securities to maturity (rather than to their interest rate reset dates) can quantify this risk. If a portfolio is constrained around realizing unrealized losses or a goal of maintaining market values within very close margins to cost (in the case of stable value LGIPs) particular attention should be paid to exposure to credit-based instruments.

More on Expanding Federal Deposit Insurance

Governing has a provocative piece by Girard Miller (How Public Cash Managers Can Navigate Buoyant Times)  that suggests treasurers and public fund managers should push for expanded and targeted federal deposit insurance.   It’s another perspective on the  recent Beyond the News piece Banking Crisis + 1 Year:  Should Federal Deposit Insurance Reform, Be Part pf the Response?. It is worth reading!