Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.
American writer and humorist Mark Twain once quipped that reports of his untimely death had been “greatly exaggerated.” Not so with the impending demise of the London Interbank Offered Rate (LIBOR). The Financial Conduct Authority (FCA), administrator for LIBOR, has warned market participants to transition to alternative reference rates (ARRs) in advance of LIBOR’s planned cessation on 31 December 2021.
To the extent that LIBOR underpins more than US$300 trillion in loan contracts and financial assets worldwide, its upcoming sunset will mark a significant change, to say the least.
Industry working groups around the globe have already selected alternative rates to replace interbank offered rates (IBORs), but each is at a different stage of adoption. Additionally, in the absence of clear “fallback” language, bonds that mature after 2021 may face considerable ambiguity, interest-rate risk, and litigation risk.
Given the sheer number and breadth of securities that currently reference LIBOR, we believe thoughtful planning and preparation now will be critical to a smooth, successful post-2021 transition for client portfolios.
Complacency and challenges ahead of the transition
Despite warnings from regulators, central banks, and industry working groups, some market participants appear complacent about LIBOR’s approaching demise at the end of 2021. To some degree, this reflects a recognition that the COVID-19 crisis may complicate the timeline to shift to ARRs.
Global central banks, which had been leading the charge to wean issuers off IBORs, have already offered reprieves amid the ongoing crisis. The Bank of England granted a six-month extension to issue new loans tied to LIBOR, while the US Federal Reserve’s US$600 billion lending program will use LIBOR as its benchmark. Thus far, however, the FCA has remained steadfast in its deadline to adopt ARRs by the end of 2021.
Although some progress has been made, as of this writing, new securities referencing LIBOR continue to be issued with inadequate, ambiguous, or inconsistent fallback language. Market pricing across most sectors does not yet appear to assign appropriate risk premiums to securities with poor fallback language. Challenges also remain with regard to transitioning legacy securities to ARRs.
The complacency, potential delays, and hurdles notwithstanding, we believe prudent planning dictates that investors should prepare for LIBOR to expire on schedule by the end of 2021.
SOFR gaining traction, but questions remain on viability
Among the various LIBOR replacement alternatives, the Secured Overnight Financing Rate (SOFR) appears to have gained the most traction. SOFR already has a swaps index, forward curves, and a futures market with quotes out to two years. Additionally, the volume of securities that reference SOFR has continued to grow (Figure 1).
However, issues with SOFR remain unresolved, namely the lack of both a term premium and a credit premium necessary to make it more comparable to LIBOR. Industry working groups are aware of these deficiencies and have proposed adjustments to mitigate potential adverse effects on a security’s value or liquidity. Market participants, in conjunction with these working groups, are in the process of building out a term SOFR curve with a stated objective of having it available well before the end of 2021.
There are also discussions involving the possibility of an alternative credit-based benchmark, but SOFR remains the most viable potential solution in the US at this time.
Fallback language varies across legacy products
Current fallback provisions in most existing floating-rate notes that reference LIBOR fail to adequately identify procedures for replacing LIBOR and would likely require a difficult renegotiation process. To address the shortcomings of existing contracts, the Alternative Reference Rate Committee (ARRC) convened by the US Federal Reserve has formed working groups of industry experts to direct the transition by specific product type. For legacy cash products, the inclusion of fallback language varies broadly and can differ by asset class, contract originator, and even origination date (as industry practices have evolved over time), which poses unique challenges for products that mature beyond 2021.
Figure 2 summarizes our assessment of the challenges presented by this transition across fixed income products that reference LIBOR.
Wellington is now in the midst of attempting to categorize, decipher, and evaluate the legal fallback language for thousands of securities in the market that reference LIBOR, with a primary focus on securities that mature after the end of 2021.
Key events that will test market preparedness
We expect progress on unresolved regulatory and data-based questions to be made in 2020, but we remain attentive to risks posed by the transition. A key event that should bring further clarity to the transition is set to occur in October 2020, at which time the US central counterparty clearing house and its London-based counterpart will implement a so-called “big bang” approach to discounting cleared swaps as they switch over to SOFR from the federal funds rate. Industry working groups hope this event will further deepen the SOFR market and aid in developing a term curve, which could help solve one of SOFR’s deficiencies compared to LIBOR — the other being the credit spread premium.
Legislative solution ideal in theory, but challenging in practice
Given the impracticality of amending existing contracts for certain LIBOR-based securities, particularly those that require 100% consent, the ARRC has proposed a legislative fix. As many security types that reference LIBOR are governed by New York state law, legislative action could establish a clear path to convert these securities to alternative reference rates and avert the potential negative consequences of LIBOR cessation. The legislative proposal would minimize legal uncertainty and ensure no economic impact on either the lender or borrower from switching rates.
Final thoughts on moving away from LIBOR
Multiple business, operational, financial, and risk decisions need to be considered and taken as the market transitions away from LIBOR. Importantly, at some point, non-LIBOR benchmarks should be used for new accounts, while existing benchmarks will need to migrate to an alternative rate. In addition, investment management partners should have developed comprehensive risk-oversight protocols designed to identify, measure, monitor, and manage on an ongoing basis the financial and non-financial risks of transition.
While this process will no doubt create uncertainties, we believe regulators and investors alike will strive to avoid major market disruptions. Each type of instrument will change at different speeds, but recent data show the market has already begun to transition, well ahead of the deadline. Continued planning and preparation will be essential as 2020 turns to 2021 and LIBOR nears extinction.