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CMBS: SOFR introduced in CMBS bonds, but not in underlying loans

| January 9, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Freddie Mac became the first to issue commercial mortgage-backed securities linked to the secured overnight financing rate (SOFR), the eventual replacement of LIBOR. The FHMS KF73 is an $850 million deal, where the $200 million AS class has a floating rate coupon of SOFR + 67 bp, and the $565 million AL class has a coupon of 1-month LIBOR + 60 bp. Both the AL and AS tranches have a 9.5-year weighted average life and are guaranteed by Freddie. Although the AS bonds are pegged to SOFR, all of the underlying commercial mortgage loans are tied to 1-month LIBOR. This leaves Freddie managing the basis risk should forward-looking 1-month LIBOR fall relative to the backward-looking 30-day compounded SOFR average; then Freddie would need to cover the shortfall between the LIBOR coupon payments of the underlying collateral and the SOFR-linked payments of the AS tranche of securities. Curiously, there remains a 5.1 bp spread difference between the first AL (2.29713%) and AS (2.24629%) coupons. The historical mean difference between 1-month LIBOR and overnight SOFR is 8.25 bp, and the mean difference between 1-month LIBOR and 30-day compound average SOFR is 15 bp, though the market did not require Freddie to close the gap, according to analysts at Commercial Mortgage Alert. Regulators, issuers and market participants continue to prepare for the end of 2021, when LIBOR is expected to be decommissioned. The GSEs have already adopted fallback contract language which will allow both the underlying loans and the securities to transition to a new benchmark rate, which is expected to be SOFR. The article is available in the 12/20/2019 issue of Commercial Mortgage Alert (subscription required). (CMA, APS)

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