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Is LIBOR Going Away?
By Frank Ossino | Senior Managing Director, Senior Portfolio Manager, Newfleet Asset Management
On July 27, 2017, the U.K. Financial Conduct Authority (FCA) announced its intention to phase out LIBOR (London Interbank Offered Rate) by the end of 2021. LIBOR underpins more than $350 trillion of financial products including swaps and derivatives, student loans, home mortgages, and other types of credit, including the large corporate non-investment-grade loan market. The idea of replacing this interest rate benchmark has been discussed frequently in the wake of the 2008 financial crisis and a very public LIBOR manipulation scandal.
WHAT DO WE KNOW?
In 2014, the Alternative Reference Rates Committee (ARRC) was formed to work with market participants to identify options for replacing LIBOR. In June 2017, ARRC announced its preferred alternative to LIBOR, the Broad Treasuries Repo Financing Rate U.S. government debt as collateral. BTFR was selected due to its liquidity and depth, with an average daily trading volume of $660 billion, and the expectation that it will remain robust over time. Additionally, BTFR’s construction, governance, and accountability are consistent with the International Organization of Securities Commission (IOSCO)’s Principles for Financial Benchmarks. To be clear, BTFR is not replacing LIBOR today—it has merely been identified as a possible appropriate replacement reference rate that, along with others, will be debated and tested across those markets that are impacted.
WHAT DOES THIS MEAN FOR FLOATING RATE LOAN PORTFOLIOS?
It is still too early to come to any conclusion on how the LIBOR issue will be resolved, but we believe any transition to a new reference rate can be adequately addressed and accomplished with time and an agreed-upon process. All parties involved, including regulators, do not want to see a broad market disruption.
Existing loan market documentation typically provides for a temporary or fallback secondary rate (such as base rate or prime rate) in the event LIBOR is temporarily unavailable. As a new reference rate is developed, we expect standard documentation language to be created, greed upon by the market, and added to new credit agreements. Given the long lead time and turnover rate of loans in the loan market, existing credit agreements may be addressed via individual amendments over the course of the life of a borrower’s loan.
Overall, we believe the loan market finds itself at a good starting point regarding the potential phasing out of LIBOR and should be able to adequately transition to a new reference rate with minimal disruption. We anticipate that regulators will tackle larger markets first or those that are initially less equipped to smoothly transition. Such markets include the derivatives and swaps market or the collateralized loan obligations (CLO) market, where transactions may not include adequate fallback language and are bespoke, making any change in documentation, including a new reference rate, potentially very difficult and cumbersome.
Moving forward, key steps will be the ultimate selection of a new rate, its phase-in across multiple markets of varying size and liquidity, and the orderly phase-out of LIBOR. Given the magnitude and complexity of the change, this may take more than the five-year horizon proposed by the FCA and may result in LIBOR surviving in some improved form for certain markets or transactions. In the meantime, loan market investors, legal counsel, the banks, and the Loan Sales and Trading Association (LSTA) are already fully engaged on the issue including meetings with ISDA (the International Swaps and Derivatives Association), the Fed, and the Treasury. As a new rate is developed, it will work with members (including ourselves) to strengthen fallback language, facilitate an orderly transition, if necessary, and draft appropriate language for credit agreements.
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.
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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