The Alternative Reference Rates Committee (ARRC), a group led by the Federal Reserve Bank of New York, published its "Second Report on Transition from LIBOR." The release explains, "The Alternative Reference Rates Committee (ARRC) today issued a new report summarizing the choice of the Secured Overnight Financing Rate (SOFR) as its recommended alternative to U.S. dollar LIBOR and enhancing the ARRC's Paced Transition Plan seeking to promote the use of SOFR on a voluntary basis." We review the latest on this new money market index, and we also quote from a recent article on ultra-short bond ETFs, below. (Note: Our upcoming Bond Fund Symposium, which is March 22-23 in Los Angeles, will discuss ultra-short bond fund and ETF issues in depth. We hope you'll join us!)
The NY Fed's release explains, "SOFR is a fully transactions based rate that will have the widest coverage of any Treasury repo rate available and it will be published on a daily basis by the Federal Reserve Bank of New York beginning April 3, 2018. Because of its range of coverage, SOFR is a good representation of the general funding conditions of the overnight Treasury repo market. As such it will reflect an economic cost of lending and borrowing relevant to a wide array of market participants active in these markets, including broker dealers, money market funds, asset managers, insurance companies, securities lenders and pension funds."
It tells us, "The report estimates the size of activity that currently references U.S. dollar LIBOR at $200 trillion dollars, 25 percent higher than previous estimates. While nearly 95 percent of this activity is in derivatives contracts, the report also shows that U.S. dollar LIBOR is used in cash products including loans, floating rate debt, and securitizations. The vast scale and broad scope of this activity underscores the necessity of promoting robust alternatives to LIBOR."
The full report comments, "In June 2017, the ARRC announced a broad Treasury repo financing rate, SOFR, as its recommended alternative to USD LIBOR. The ARRC considered a comprehensive list of potential alternatives, including other term unsecured rates, overnight unsecured rates such as the effective fed funds rate (EFFR) and overnight bank funding rate (OBFR), secured repo rates, Treasury bill and bond rates, and overnight index swap (OIS) rates linked to EFFR. After extensive discussion, the ARRC preliminarily narrowed this list to ... an overnight unsecured rate (the OBFR) and some form of overnight Treasury repo rate.... The ARRC made its final choice of SOFR after incorporating feedback from the consultation and from the members of the Advisory Group."
It states, "SOFR is a fully transactions-based rate incorporating tri-party repo data, the Fixed Income Clearing Corporation's (FICC) GCF Repo data, and bilateral Treasury repo transactions cleared through FICC.... It will have the widest coverage of any Treasury repo rate available. [T]he transactions underlying SOFR regularly exceeded $700 billion in daily volumes last year and have been growing. Over the first half of 2017, the average daily volume of transactions underlying SOFR was $754 billion, representing the largest rates market at any given tenor in the United States.... The volumes underlying SOFR are far larger than the transactions in any other U.S. money market and dwarf the volumes underlying LIBOR or other term unsecured funding rates."
The report also says, "Because of its range of coverage, SOFR is a good representation of general funding conditions in the overnight Treasury repo market. As such, it will reflect an economic cost of lending and borrowing relevant to the wide array of market participants active in these markets.... Although the ARRC seriously considered OBFR as its other leading candidate, a Treasury repo rate like SOFR was seen as potentially more resilient both by the ARRC and by the ARRC's Advisory Group of end users, a clear majority of whom preferred a repo rate.... Money market fund reforms have also led to some decline in unsecured overnight transactions volumes since 2016. In contrast, Treasury repo markets were seen as more resilient and an active source of funding for a wide range of market participants."
Finally, the release describes ARRC as a "group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York in cooperation with the U.S. Department of the Treasury, the U.S. Commodity Futures Trading Commission, and the Office of Financial Research. Its mission is "to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market."
In other news, The Wall Street Journal featured an article yesterday, entitled, "Investors Warm Up to Bond ETFs." It says, "Fixed-income exchange-traded funds are late bloomers compared with their equities-based cousins. But their popularity has surged in recent years -- with funds focused on shorter-duration bonds drawing interest lately -- as investors look to marry the benefits of fixed income with the advantages of an ETF."
The piece explains, "According to an October report from BlackRock Inc., assets under management in bond-focused ETFs have grown 25% annually for the past five years and are likely to reach $1.5 trillion by 2022. As of mid-February, there was $780 billion in these products, representing 15% of the total ETF market, according to BlackRock's iShares division, the biggest U.S. ETF firm by assets."
The Journal continues, "Bond ETFs attracted $138 billion in new assets in 2017, up from $112 billion in 2016, according to ETFdb.com analyst Neelarjo Rakshit, who says a number of factors are driving the growth. For starters, he says, an overall boom in passive-investing strategies means there are simply more options available for ETF investors.... Additionally, while fixed-income ETFs usually pay regular interest payments like bonds, they also offer the benefits of an ETF, such as intraday trading, liquidity, transparency and a relatively low cost compared with mutual funds."
The article tells us, "Individual investors have grown more comfortable with fixed-income ETFs, says Kathy Jones, senior vice president and chief fixed-income strategist at the Schwab Center for Financial Research. Schwab says assets under management in the U.S. fixed-income ETFs on its brokerage platform rose to $64.1 billion in 2017 from $49.4 billion the year before. Schwab saw inflows of $12.6 billion into the fixed-income funds over the course of 2017, just over a quarter of the total flows into ETFs.
It adds, "Most of the money flowing into these products now is going into ETFs focused on shorter-duration bonds, Ms. Jones says, a trend noted by other ETF providers. That is due to interest-rate increases by the Federal Reserve and the expectation of more to come this year, she says. Rising interest rates have a negative impact on the price of existing bonds, particularly those with a longer duration. By buying shorter-term funds, investors can stay invested in fixed income, but mitigate some of the impact of rising rates, she notes."
