BENCHMARK RATE SOFR HAS CAUGHT ON. BUT ONE VERSION IS COSTING COMPANIES MORE TO HEDGE / THE WALL STREET JOURNAL

Benchmark Rate SOFR Has Caught On. But One Version Is Costing Companies More to Hedge

A successor to the tainted Libor rate, SOFR is gaining wide acceptance. Its term version can help businesses forecast cash, but it can cost more to hedge than the overnight rate due to restrictions on banks

By Mark Maurer

Asbury Automotive Group financed the real estate associated with its $3.2 billion purchase of Larry H. Miller dealerships last year in overnight SOFR. Term SOFR, CFO Michael Welch said, was 3 to 4 basis points more expensive./ PHOTO: ASBURY AUTOMOTIVE GROUP INC.

Companies are paying more to hedge a forward-looking interest-rate benchmark that is being widely used to replace the troubled London interbank offered rate, an added expense that comes as finance chiefs are looking to cut costs.

Benchmark rates such as Libor underpin trillions of dollars of financial contracts, such as corporate loans, mortgages and interest-rate derivatives. 

Most companies have picked the Secured Overnight Financing Rate, or SOFR, as their replacement for Libor, which is being phased out after a manipulation scandal. 

Libor is set to expire June 30, 2023.

Banks, which offer derivatives to corporate borrowers, are restricted from hedging so-called Term SOFR themselves, which in recent months has allowed more risk to creep onto their books. 

Banks pass along that risk to corporate borrowers or parties to a derivative contract in the form of higher costs. 

Term SOFR, unlike the also popular overnight version of SOFR, particularly benefits companies that borrow or lend in one-, three- or six-month periods, and helps project their interest expense.

But companies are looking closely at those higher hedging costs, and weighing whether Term SOFR is their best benchmark-rate option as they also grapple with steeper expenses in raw materials, freight, energy and labor. 

While the longer-term version of SOFR helps businesses forecast cash, it is also pricier, due to the hedging restrictions placed on banks.

For a typical five-year, $1 billion trade, an extra 3 basis points between Term SOFR and the overnight version would cost the company an estimated $1.5 million over the life of the trade, said Amol Dhargalkar, managing partner and global head of corporates at Chatham Financial, a financial-risk adviser.

“It’s a meaningful incremental cost,” he said.

Still, businesses that have already locked in at Term SOFR rates to finance loans and floating-rate debt likely don’t want to bother arranging a switch with their lender, Mr. Dhargalkar said. 

Cost is also unlikely to prompt firms to reduce their hedging of Term SOFR at a time of high volatility in short-term rates, he said.

Vehicle retailer Asbury Automotive Group Inc., however, plans to evaluate whether to switch from the overnight SOFR rate to Term SOFR next year at the earliest, as the rates gain further traction in the market, Chief Financial Officer Michael Welch said.

Last year, the Duluth, Ga.-based company used overnight SOFR, instead of Term SOFR, to finance the real estate associated with its $3.2 billion purchase of dealerships from rival Larry H. Miller Co. 

The company used the overnight rate because Term SOFR was pricier by 3 to 4 basis points for certain derivative contracts at the time, he said.

Since then, Asbury Automotive has changed over all its Libor-based debt—totaling more than $1.2 billion—to overnight SOFR, he said.

“There’s some benefit to Term SOFR, but at the end of the day, the cost is all that matters,” Mr. Welch said, adding that Term SOFR bore similarities to the company’s former Libor rate, like its smooth month-end invoicing process. 

“The fact was SOFR was cheaper at the time.”

Term SOFR hedging costs are likely to go up more by year-end, said Tom Deas, chairman of the National Association of Corporate Treasurers, a professional group. 

The current cost of 1 to 3 basis points above overnight SOFR could increase to 6 to 7 basis points, he said.

“If we get another volatile spike, that’s when companies will really pay,” he said, referring to a global disruption such as another pandemic. 

Banks’ capacity to take on more Term SOFR exposure would also likely be filled quickly, causing hedging costs to rise, he said.

Hersha Hospitality Trust, a Philadelphia-based real-estate investment trust, estimates its hedging costs are 1 to 3 basis points above what it paid to hedge Libor, but isn’t a significantly higher amount yet, CFO Ashish Parikh said.

“If they do rise to a significant level, then we would absolutely look at something else,” Mr. Parikh said. 

“I would be more than a little annoyed if it got to be that level,” referring to a 5-basis point difference. 

The REIT plans to switch its $100 million in hedged Libor-based debt to Term SOFR by year-end, he said. 

Hersha hasn’t decided on a price point yet, he added.

Even with less than a year till Libor’s demise, many businesses still have loans on their books tied to the rate, which they often then hedge. 

In June, average daily trading volumes of SOFR-based derivatives for the first time exceeded those linked to Libor.

In July, roughly $2.55 trillion globally of futures and options contracts tied to SOFR changed hands each day, up from $151.55 billion in the same month a year ago, according to exchange operator CME Group Inc. 

The figures reflect one- and three-month contracts based on overnight SOFR.

In contrast, about $1.75 trillion in Libor-based derivatives were traded a day in July, down from $3.31 trillion a year earlier.

The Alternative Reference Rates Committee, a group of financial firms handling the U.S. transition from Libor with the Federal Reserve Bank of New York, in July of last year endorsed Term SOFR and recommended that companies and banks limit their hedging of the rates, which CME then applied as a restriction on lenders. 

The move was aimed at preventing the same manipulation that befell Libor and keeping the financial system stable.

The ARRC advises companies and lenders to use overnight SOFR in most cases due to its resilience to market shifts. 

But the committee still supports the use of Term SOFR for corporate-loan deals given its similarity to Libor.

“We knew that the banks would be warehousing some of this basis risk” to offer Term SOFR, said Tom Wipf, head of the ARRC and vice chairman of institutional securities at Morgan Stanley. 

“That’s one of the issues that we’re digging into now.”

In June, the ARRC reconvened a task force to assess transition-related issues—in particular the impact of the Term SOFR restriction on banks and companies—in an effort to reduce the costs companies are facing, Mr. Wipf said. 

The group expects to issue further clarification in the next couple months, he said.