By the Numbers

Mind the basis

Mary Beth Fisher, PhD | February 24, 2023

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.

With LIBOR sailing off into the sunset at the end of June, agency CMBS has taken a hybrid path to quoting spreads. The new issue market quotes spreads to the SOFR curve (P spreads) while the secondary market typically quotes spreads to the Treasury curve (I or J spreads), which is the more common convention in non-agency CMBS. Investors consequently need to keep an eye on the SOFR-to-Treasury basis to make relative value calls between new issue and secondary opportunities.

The spread between matched-maturity Treasury rates and SOFR swap curve rates, or the SOFR-to-Treasury basis, is not as volatile as the LIBOR-to-Treasury basis primarily because so far the SOFR swap curve itself is not as volatile. That’s to be expected since SOFR swaps are based on secured, risk-free SOFR rates as opposed to LIBOR, which was based on unsecured, interbank borrowing rates. Still, when markets melted down in March 2020 at the beginning of the pandemic, the SOFR-to-Treasury basis across tenors became quite volatile as well (Exhibit 1).

Exhibit 1: SOFR-to-Treasury basis spreads across the curve

Note: The Treasury curve is assumed to be the base curve, so the spread is calculated as the SOFR rate minus the matched-maturity benchmark Treasury rate. Data through 2/23/2023.
Source: Bloomberg, SCIB US

Similar to the LIBOR swaps curve, the SOFR swaps curve currently lies below the Treasury curve for longer maturities, so the spreads are negative (Exhibits 2 and 3). Some short maturity spreads are currently positive arguably because the SOFR swaps curve follows the implied forwards priced into short term funding markets with more precision than Treasury bills.

Exhibit 2: SOFR curve, actual Treasury curve and nominal Treasury curve

Note: The differences between the actual benchmark maturities (I curve) and the nominal benchmark maturities (J curve) are currently very small due to recent Treasury note auctions. These can be up to 0.25 years e.g. right before a 10-year auction when new bonds are issued quarterly. The nominal maturity is still 10 years but the actual maturity is 9.75 years. The swap curve points are always consistent with the nominal maturity points. Bloomberg uses linear interpolation between the points when calculating spreads to the curves for structured products, not the smoothed interpolation shown above.
Source: Bloomberg, SCIB US

The widest basis is currently in 1-year tenor (26 bp), with the most negative basis at the 30-year tenor (-68 bp). Unlike the LIBOR basis, as rates rise and the curve eventually normalizes from its steep inversion, it is likely that the SOFR curve remains negative for most tenors across the curve.

Exhibit 3: SOFR-to-Treasury basis term structure

Source: Bloomberg, SCIB US

The volatility of SOFR / Treasury basis needs to be factored in when agency CMBS investors are considering relative value between new issues, which are priced using P spreads off the SOFR curve, and in the secondary market which commonly uses J spreads off the Treasury nominal curve.

Exhibit 4: Yield spread / curve methods

Note: There are many more yield spreads on Bloomberg. These are the most commonly used in the CMBS and SFR space. The spreads when used in structured products typically calculate the yield difference between the bond and the underlying curve using the bond’s weighted average life, not the final maturity.
Source: Bloomberg, SCIB US

A new issue agency CMBS, for example a 10/9.5 DUS, is currently coming to market at a P spread of 91 bp for a 4.50% yield (Exhibit 5). A 10-year Treasury rate of 3.88% would imply an equivalent J spread of 62 bp. The quickest translation if for investors to simply add the appropriate basis spread to the P spread to get equivalent J spread (91 – 28 = 63, net of rounding). In this example the actual maturities were used instead of the WAL for the spreads, so make adjustments for seasoned bonds.

Exhibit 5: Current new issue DUS pricing

Note: Data as of 2/23/2023.
Source: Bloomberg, SCIB US

Monitoring the basis is particularly relevant when looking at shorter maturity or WAL bonds. The volatility, or standard deviation, of the 2-year SOFR-to-Treasury basis is 9 bp, which is as large as the current spread (Exhibit 6).

Exhibit 6: Current SOFR / Treasury basis statistics

Source: Bloomberg, SCIB US

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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