As the transition away from Libor (the London Interbank Offered Rate) as the industry-preferred floating-rate benchmark continues, many investors are raising concerns about how both new and existing short-term and floating-rate instruments currently indexed to Libor will adjust when Libor is no longer available.
The short answer is that although official sector working groups have convened and taken initial steps in designing and implementing transition plans, there still remain unanswered questions that could leave many issuers and markets in Libor limbo. But proposals are well underway that if enacted could help clarify the transition. Or if the limbo persists, another option (at least in theory) is an extension of Libor beyond its current 2021 end date – but investors should not rely on that.
We are seeing some progress: Many markets are beginning to turn to alternative rates. One of these rates, the Secured Overnight Financing Rate (SOFR) published by the Federal Reserve Bank of New York, is gaining some traction particularly in security markets. Issuance of SOFR floating-rate deals has increased in response to investor demand, albeit from very low levels. However, the gradual increase in issuance is not a complete gauge of progress toward widespread market adoption of SOFR. In our view, the sign of meaningful progress is more issuers (both financial and nonfinancial) utilizing SOFR more frequently as a viable index. Regulatory agencies and issuers need to take several more steps in this direction, and risks and uncertainties are clouding the path.
Efforts to encourage SOFR adoption
We believe that liquidity in the SOFR-indexed derivative market is a necessary precondition for greater issuance in larger- and longer-maturity corporate floating-rate debt as well as for expanded use of the rate in other products such as loans, mortgages and other consumer products.
To help pave the way, the Federal Reserve Bank of New York aims to publish a backward-looking compounded form of the overnight rate. Compounding the SOFR rate over a specific term (period of time) should help smooth the impact of any realized short-term volatility in SOFR in overnight markets, such as we witnessed in year-end 2018. In the U.K. and U.S., the public sectors are also planning to publish a forward-looking term rate for SOFR based on expectations from the derivative markets.
Fallback language in new issues
Many markets have not yet embraced the transition to alternative rates. Enhanced fallback language in new issue contracts would provide greater certainty and alignment for any new bonds still linked to Libor. The Alternative Reference Rates Committee (ARRC) at the New York Fed issued consultations on language that – if included in new Libor deals – would greatly enhance the ability of a cash-equivalent security to adjust if Libor is no longer available. Ideally we would see consistency across calculation methodologies and fallback triggers for new issues, but operational issues could prevent that. Investors should be aware of the potential for basis risk if cash flows and methodologies are not perfectly aligned.
Risks surrounding legacy cash-equivalent investments
In our view, one of the greatest risks in the market transition away from Libor concerns legacy cash-equivalent investments. Back in 2017 we noted how the constrained ability to amend legacy cash-equivalent securities limits the options for transitioning them to new benchmark rates. Recent speeches from policymakers at the U.K. Financial Conduct Authority (FCA) likewise acknowledged this risk, and also made subtle references that a continued publication of Libor may be a potential solution to easing disruption in liquidity markets.
That said, investors shouldn’t rely on an extension of the Libor deadline. We believe that regulators should focus not only on fostering new reference rates (including SOFR), but also on assessing and managing the consequences for assets whose referenced index cannot be easily transitioned away from Libor.
Preparing portfolios for several scenarios
At PIMCO, we continue to support market initiatives to establish alternative rates that are robust and representative of actual transactions. Our portfolio management teams have reviewed potential outcomes following a Libor discontinuation, including performing scenario analysis on securities whose cash flows may be linked to Libor after its current 2021 end date. The uncertainty regarding the timing and nature of a Libor discontinuation underscores the risks of being complacent in preparing for a future without Libor.
Read our companion blog post on how derivatives markets are transitioning away from Libor.
Courtney Garcia is a portfolio risk manager, and Jerome Schneider is head of short-term portfolio management.