In late 2020, U.S. regulators Footnote[i] issued supervisory guidance encouraging banks to stop entering into new financial contracts that reference U.S.-dollar-denominated Libor (the London Interbank Offered Rate). The regulators set a deadline of 31 December 2021 to transition all contracts away from Libor. They also indicated that any Libor-referenced contracts in the interim should have a robust fallback with a clearly defined alternative rate. The statement from the regulators applied to all financial contracts that reference Libor, implicating leveraged loans, a floating-rate sector that has long used Libor.
Since 2017, the Alternative Reference Rate Committee (ARRC) – a group of market participants (including PIMCO) convened by the Federal Reserve Board and the New York Fed – has recommended that the Secured Overnight Financing Rate (SOFR, a reference rate published by the New York Fed) replace USD Libor. The ARRC also recommended “hardwired” fallback language be used in both syndicated and bilateral loans beginning in the autumn of 2020, and that banks stop originating Libor-referenced leveraged loans after 30 June 2021.
Yet, despite prompts from regulators and market participants, the U.S. leveraged loan market has been slow to embrace SOFR, even while other fixed income sectors issue new SOFR-referencing contracts. This lack of progress has most recently caught the attention of U.S. Treasury Secretary Janet Yellen, who noted that loans are well behind where they should be at this stage in the transition. We believe continued delay could elevate risks for both loan issuers and investors during the delicate transition away from Libor.
What does this mean for the market?
In our view, floating-rate new issues that come to market before year-end 2021 should take one of two approaches to ensure a smooth transition away from Libor. The first is to issue loans with contracts based on the benchmark rate that the ARRC has recommended after years of iterative work: SOFR. While we understand that SOFR may not be the panacea and that the market may evolve over time to favor another reference rate, we believe that during the fragile transition away from Libor, coalescing around the ARRC’s recommended benchmark makes the most sense from a market stability perspective. The second is to issue a loan with a Libor-indexed contract that, as recommended by the ARRC, includes a fallback mechanism that will transition the contract to SOFR when Libor ceases.
Either option presents a straightforward solution. Still, U.S. leveraged loan participants have yet to make even a single new SOFR-based loan and, perhaps more concerning, they are accepting a variety of fallback provisions, rather than embrace SOFR as the fallback (the ARRC’s standardized and generally accepted protocol). Banks’ inconsistency in adopting a single fallback has created uncertainty around which rate(s) the loan market will reset to once Libor is no longer available, introducing potential fragmentation and market risk for investors in these new loans. Accordingly, investors should monitor and take steps to mitigate these risks.
Why the delay?
Some loan market participants have argued that because the first option in the ARRC’s fallback waterfall is term SOFR, they believe they must wait for the ARRC to formally approve a specific term SOFR rate before issuing SOFR-based loans or adopting the ARRC-recommended fallback. But we don’t believe a specific term SOFR rate is imperative: There already exists a deep, liquid overnight SOFR market, which is the basis of the second recommended rate in the ARRC’s fallback waterfall. Already, tens of billions of dollars in SOFR-indexed contracts that pay compounded interest based on this daily SOFR rate have come to the market across a variety of fixed income sectors, outside of loans. Additionally, hundreds of billions of dollars in Libor-indexed contracts have been issued using the ARRC’s fallback language.
Other loan market participants have also recently argued that they should take a wait-and-see approach to determine if the market’s recent experimentation with credit-sensitive alternatives to SOFR is viable for loans. This approach risks fragmenting the market and curtailing liquidity, and may imperil the smooth transition from Libor as the regulators’ year-end 2021 deadline fast approaches. In a recent statement to the Financial Stability Oversight Council, SEC Chair Gary Gensler pointed out flaws in these credit-sensitive alternatives, and how they may be no different than Libor; and Fed Governor and Vice Chair for Supervision at the Federal Reserve, Randal Quarles, recently reminded the market that SOFR is one of the most stable, deep and liquid markets in the world, which is why the ARRC chose SOFR over other alternative rates.
The collective good
A key ARRC goal is minimizing value transfer. If lenders and borrowers embrace the ARRC’s recommendations, they will likely incur minimum costs transitioning away from Libor, and collectively reach the goal of market stability (or at minimum, not increase the risk of market instability). To achieve this, we believe lenders and issuers must quickly and consistently adopt a single benchmark. We know that no one rate will ever be perfect, but having multiple benchmarks competing against each other and against a year-end deadline will result in fragmentation, diminished liquidity and increased transaction costs for the U.S. leveraged loan market.
For further insights into financial markets’ transition away from Libor, read our recent blog post, “Short‑Term Reference Rates at a Crossroads.”
David Forgash is a portfolio manager and head of PIMCO’s leveraged loan business. Libby Cantrill is PIMCO’s head of public policy. Bryan Tsu is a portfolio manager focused on commercial mortgage-backed securities and collateralized loan obligations. All are contributors to the PIMCO Blog.