Written by Frank Ossino, Senior Managing Director, Senior Portfolio Manager, and Bank Loan Sector Head, Newfleet Asset Management
Though the plan to phase out LIBOR (London Interbank Offered Rate) is two years away, it has been the subject of recent headlines. We thought this would be a good opportunity to provide an update on Newfleet’s view regarding the announcement of the discontinuation of LIBOR, which is scheduled to happen at the end of 2021, and its potential impact on the loan market. Is it a Principal Risk?
Recall we wrote a short piece describing the event in 2017 called Is LIBOR Going Away? Our most recent thoughts on this topic are below.
Currently, it is our view that the anticipated cessation of U.S. Dollar LIBOR is not a principal risk to the broadly syndicated loan market. We are defining ‘principal risk’ as a risk that is systemic to the proper functioning of the loan market. To be clear, there could be market volatility during the transition in the form of loan price volatility (basis risk), collateralized loan obligation (CLO) arbitrage volatility (basis risk), and general potential operational/contract booking-related issues (technology or systems risk), to name a few, but we believe the market will work through these potential initial challenges. Our thoughts are based on the following:
- The Alternative Reference Rates Committee (ARRC) and other global organizations tasked to find a replacement rate have been working on the issue for some time now. The Loan Syndications and Trading Association (LSTA) is involved in the discussions. Every major market has landed on an alternative to its respective LIBOR replacement, including Europe, the UK, Switzerland, and Japan.
- In the U.S., the Secured Overnight Financing Rate (SOFR) has been developed as the replacement rate. The rate has already been used in a number of debt issuance transactions and a derivative market is now developing. While we are finding the rate to be slightly more volatile than LIBOR, performance of SOFR has generally been in line with expectations and trading in the rate continues to grow. The next step for SOFR will be to develop a term structure.
- Regarding loan market transition, we are beginning to see loan credit agreements with revised fallback language that walk through the trigger events that “trigger” the transition from LIBOR and the waterfall selection of a replacement rate (plus a possible spread adjustment based on the difference between LIBOR and SOFR, if necessary). The ARRC, International Swaps and Derivatives Association (ISDA), and others are all involved in the waterfall used in selecting what SOFR rate and spread adjustment may be used (Forward Looking SOFR versus Compounded SOFR, for example).
- Note that loan credit agreements already have fallback language in the event that LIBOR is not able to be calculated. Traditionally, the fallback rate has been the prime rate and the solution was intended to be for short periods of time. Regardless, while the prime rate is not considered an equivalent rate to LIBOR (primarily due to the higher cost to the borrower), in the event that existing credit agreements needed an alternative rate while SOFR continued to be developed, the prime rate is an existing option, and processes are already in place for this alternative rate.
- Lastly, in a worst case scenario, if markets were still not ready for the cessation of LIBOR and the transition to a replacement rate, we believe the cessation date could be delayed or pushed out as markets continue to work through the transition challenges.
Collateralized Loan Obligations are securities backed by a pool of assets often low-rated corporate loans.
The London Interbank Offered Rate (LIBOR) is the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London.
Newfleet Asset Management’s industry trends and observations are the result of research conducted by the portfolio management/research team. These observations reflect their industry expertise and have been prepared using sources of information generally believed to be reliable; however, their accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice.
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