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LIBOR’s Final Countdown
- By Gary Horbacz, CFA, Principal, Structured Products and Jason Pan, CFA, FSA, Vice President, Structured Products
- November 13, 2020
The transition from USD LIBOR to an alternate interest rate has been a focus of regulators and market participants worldwide since at least July 2017 and a smooth transition is essential to avoiding market disruptions given the volume of impacted contracts. In the U.S., the Secured Overnight Financing Rate (SOFR) has been identified as an appropriate replacement index by the Alternative Reference Rate Committee (ARRC). Given the importance of the conversion, the following provides our assessment of its progress, hurdles that remain, and our approach to the transition.
Our Take on the Transition
Despite some confusion amongst market participants, we continue to believe that USD LIBOR will be published through year-end 2021 after which index cessation is likely. The UK LIBOR regulator (Financial Conduct Authority) has indicated that, by year-end 2020, it will likely determine that USD LIBOR will not be representative of borrowing costs on a prospective basis. Such an announcement would not alter our expected LIBOR timeline, but would provide certainty to the market regarding the ultimate demise of the index.
While the adoption of SOFR in the U.S. lags the UK’s adoption of its alternate rate (SONIA), we remain confident that the transition from LIBOR to SOFR for new transactions is proceeding according to plan and will be fully transitioned by December 31, 2021. The transition for certain legacy LIBOR transactions remains uncertain.
We expect SOFR derivative (swaps and futures) activity to accelerate in the near-term given a recent switch in discounting of legacy swaps from Fed Funds to SOFR. According to ISDA, in October approximately 10% of USD interest rate derivative activity referenced SOFR versus over 40% in the UK that referenced SONIA (Figure 1).
Figure 1: SOFR Derivative Activity in the U.S. Is Increasing
Use of SOFR in Cash Products
Despite likely LIBOR cessation in less than 13 months, LIBOR-based financial products continue to be issued. Thus far, the corporate bond market has led other markets in adopting SOFR, with nearly $800 billion of issuance since 2018. This compares to less than $9 billion of issuance in SOFR-based securitized products over the same time period. Business loans have lagged even further, with only a handful of SOFR-based transactions to date (Figure 2).
Figure 2: The Corporate Bond Market has Led, but Markets have Generally been Slow to Adopt SOFR
The U.S. structured products market, aside from GSE SOFR usage in a few multifamily and single-family securitizations, has thus far resisted SOFR-based issuance and instead continues to rely on USD LIBOR transactions with clearly defined LIBOR fallback provisions. Much of the resistance perhaps results from an inability to agree on a standard use of a SOFR (overnight rate) to compute a coupon for a longer tenor (e.g., 1-month, 3-month). We believe that the market will gravitate towards a simplistic “compounded-in-advance” model until a SOFR term curve is endorsed by the ARRC.
Addressing Inadequate Fallback Provisions in “Tough Legacy” LIBOR Transactions
Unfortunately, LIBOR-based cash product transactions issued prior to 2019 often lack the fallback provisions necessary to instruct counterparties to establish a floating rate coupon following LIBOR cessation. In 2019, the ARRC addressed this problem by publishing recommended fallback provisions for each sector within cash products on a forward looking basis, but transactions issued prior to 2019 remain problematic. Unlike the derivative market that accomplished a “bulk amendment” of legacy transactions, cash product transactions (aside from leveraged loans) cannot be easily amended given the need for 100% bondholder approval. Without a solution, the floating rate coupon for nearly $5 trillion “tough legacy” bonds and consumer loans will be uncertain post 2021. As a result, liquidity may be affected and court action is likely.
The ARRC has recommended legislation that, if passed, would permit transaction parties to ignore problematic provisions and instead use the ARRC-recommended fallback provisions (SOFR plus a spread adjustment). The ARRC has focused its efforts on New York State given that most bond contracts are governed by New York law, but it has also begun to discuss a potential federal legislative solution.1
While legislation is a simple and elegant solution to tough legacy contracts, progress has been slow and somewhat hampered by the COVID pandemic. We believe that, while New York state legislation would solve most of the issues surrounding tough legacy securities, a federal solution would provide further clarity for both bonds and consumer loans that are issued under state laws other than New York.
PGIM Fixed Income’s Approach to the LIBOR-to-SOFR Transition
PGIM Fixed Income represents Prudential Financial as a member of the ARRC and has been active in crafting standardized fallback language for new transactions, recommending appropriate parameters for defining the LIBOR/SOFR credit spread adjustment, and pursuing potential solutions to LIBOR cessation including legislative efforts.
The transition from LIBOR is an unprecedented milestone affecting huge swathes of the fixed income markets. As the final countdown to LIBOR cessation begins, we’ll continue to monitor the progress for a smooth transition while continuing to take the following steps:
- Maintaining a market-leading position in the transition from LIBOR to an alternative reference rate and continuing to recommend potential solutions
- Requiring issuers to incorporate improved fallback language for new transactions that reference LIBOR
- Continuing to evaluate potential outcomes for tough legacy LIBOR holdings through a deal-by-deal prospectus review to capture and categorize potential fallback outcomes
- Continuing to highlight potential transition risks to key stakeholders
This material reflects the views of the authors as of November 13, 2020 and is provided for informational or educational purposes only. Source(s) of data (unless otherwise noted): PGIM Fixed Income.
1Draft legislation which is expected to be introduced by U.S. Representative Brad Sherman (D-CA), member of the United States House Committee on Financial Services where he serves as Chairman of the Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets
Gary Horbacz, CFA
Gary Horbacz, CFA, is a Principal on PGIM Fixed Income’s Securitized Products Team. His area of credit research specialization is Commercial Mortgage Backed Securities (CMBS). Mr. Horbacz joined the team in 2000 following five years in the Firm’s Portfolio Management Group. Mr. Horbacz currently serves as a member of the Alternative Reference Rates Committee and is also a member of the Structured Finance Industry Group’s Board of Directors. Mr. Horbacz earned a BS in Management Information Systems and an MBA in Finance from Seton Hall University. He holds the Chartered Financial Analyst (CFA) designation.
Jason Pan, CFA, FSA
Jason Pan, CFA, FSA, is an Senior Associate on PGIM Fixed Income’s Securitized Products Team. His primary area of credit research specialization is Commercial Mortgage Backed Securities (CMBS). Mr. Pan joined the team in 2014 after two years in the Firm’s Actuarial Leadership Development Program. Mr. Pan earned a BS in Bioengineering from the University of Pennsylvania. He holds the Chartered Financial Analyst (CFA) designation and is a Fellow of the Society of Actuaries (FSA).
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