Libor Is Riding into the Sunset. What Next? | Lord Abbett
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Fixed-Income Insights

The interest-rate benchmark is set to be phased out by the end of next year in favor of a new standard. Here, we provide our answers to investor questions about the transition.

Read time: 5 minutes

In 2015, regulators announced that Libor (the London Interbank Offered Rate), a bond market benchmark that is linked to hundreds of trillions of dollars of assets and transactions, was ill-suited for the modern era, and would be phased out by the end of 2021.  While six years is a substantial amount of lead time for any market transition, the bulk of that time has passed.  While many needed changes are in place, market participants continue to sort out the remaining details of the upcoming transition. 

Although the transition from Libor to a new benchmark is a major change that touches many areas of financial markets, it is likely to occur with little fanfare and minimal market disruption, thanks to substantial efforts that have already been made.  However, the scale of this change is so enormous that we believe many aspects of the bond markets will be permanently altered, and that all market participants should be aware of potential exposure. Here, we answer some key questions investors may have about the Libor transition and its potential implications for fixed income.

What exactly is Libor?

Libor is the rate at which banks lend to one another for set periods of time, such as one month or three months.  When Libor was first created five decades ago,1 member banks would report the levels at which they lent to one another, and the aggregate levels were reported as a single number.  This number—three-month Libor, for example—represents short term rates that also take into account both bank credit and lending capacity.  As such, it makes for a useful benchmark for banks to link to both loans and interest rate swaps. 

However, as central banks increasingly lend directly to member banks, the number of actual interbank transactions has dwindled. So while Libor is now the reference rate for hundreds of trillions of dollars of financial transactions, it is determined by a relatively small number of actual transactions, and in some cases, merely “best judgment”.  Given this mismatch, markets did indeed need a change.

Why is Libor so important?

Libor has grown into a market standard reference rate because it is a useful benchmark for banks, but also because widespread adoption has helped it to become standardized across a wide range of asset classes.  Many borrowers and lenders have exposure, a fact that they may not even realize.  Among other things, during the decade following the collapse of the Long Term Capital Management hedge fund in 1998, interest-rate swaps based on Libor became the industry standard for managing interest-rate risk.  The outstanding float of Libor-based swaps now numbers in the hundreds of trillions of dollars.

If so many assets are tied to Libor, how can it go away?

This is why so much time is needed for the transition.  So many financial transactions are tied to Libor for a reason—it is transparent, easy to trade, and widely supported.  In order for the elimination of Libor to proceed smoothly, markets need another available benchmark in order to fill that role, and they need to sort out what happens to existing loans and assets that are already tied to Libor. 

What could replace Libor?

There have always been other benchmarks for short-term rates, but none so widely used as Libor.  The market’s adoption of Libor as the primary standard evolved over time, due in part to its characteristics, and also to the transparency and liquidity that came from prolonged usage.  The key, then, is to find a benchmark that meets both needs.  After considerable deliberation, the Alternative Reference Rates Committee (ARRC), a group of market experts convened by the U.S. Federal Reserve (Fed), has settled on a new benchmark called SOFR (Secured Overnight Financing Rate). 

This new benchmark is based on the numerous daily transactions in the U.S. Treasury repo market—essentially, where lenders are willing to lend cash overnight for a guaranteed return.2  SOFR is determined by a large number of quantifiable transactions; it is not based on guesswork, and not vulnerable to manipulation.  It also directly reflects immediate lending capacity for banks.  However, it also differs from Libor in key ways: it does not have a credit component (the overnight lending is collateralized by U.S. Treasuries), and there is no term SOFR, only overnight lending.

Are there market implications for using a different benchmark?

Yes and no.  Models and asset pricing have been calibrated for Libor, and that is being replaced by something that will behave differently.  Libor is often quoted in terms of a spread to U.S. Treasuries, and SOFR will have a lower spread.  The lack of term SOFR means that daily readings of SOFR will have more volatility than, for example, a three-month term for Libor, in our view.  Markets are already adjusting to some of these differences, but some nuances will take time for risk managers to sort through. 

Markets are also very efficient in pricing the difference.  Already, there is a well-established market for the SOFR/Libor “basis,” or the difference between the two benchmarks.  The real key to a smooth transition, in our view, is widespread adoption of SOFR, so that market participants become more comfortable with trading mechanics and liquidity.  While SOFR has been around since 2018, it has only recently seen a material increase in trading volumes (see Figure 1).  However, this volume increase is a very positive sign that the transition continues to move forward successfully.

 

Figure 1. SOFR, So Fast: Replacement Rate for Libor Is Finding Greater Market Acceptance

Monthly trading volume (three-month rolling average) in SOFR swaps, August 2019-November 2020

Source CME. Data as of November 30, 2020.  SOFR swaps are derivatives tied to the Secure Overnight Financing Rate, alternative benchmark to Libor for US dollar derivatives and other financial products established in early 2018.
For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

On October 15, the major clearing houses for interest rates swaps—the Chicago Mercantile Exchange (CME) and the London Clearing House (LCH)—converted the reference rate and discounting methodology for all existing swaps from Libor to SOFR.  Although the volumes involved were enormous, with more than $200 trillion in outstanding swaps between the two exchanges, the “Big Bang,” as the transition was referred to, was more of a “Big Sigh of Relief.”  It all happened with no discernable snags.  Since that time, there has been a notable increase in SOFR trading, as we can see in Figure 1.  These volumes likely will continue to increase, as key market participants convert their primary vehicle for trading interest rate risk from Libor to SOFR.  Libor adoption occurred over decades, so we believe this switch will take more than a few weeks.

What about all of the securities that are still tied to Libor?

Fortunately, all securities issued in the past several years have clear fallback language, so when Libor is phased out, they will reference SOFR.  Most of the existing universe of investable assets will have no issues, in our view.  However, there are still some outstanding loans with ambiguity, and this has been a major area of focus for regulators and legislators.  As it stands now, securities without any language for a new benchmark will simply continue to reference the last Libor set at the end of 2021.  Legislators are considering various fixes for what we see as a relatively minor issue, and there is also discussion about extending the Libor sunset date, so that these relatively few securities will have matured.  

What should investors do about all of this?

In our view, most investors need to do very little.  We think they should familiarize themselves with the mechanics of SOFR.  They should also consider how much exposure they may have to securities without Libor fallback language, and the possible implications of that exposure.  And they should ensure that their risk systems are able to use reference rates besides Libor, where relevant.  We believe the most obvious parallel is the Y2K transition, where there were legitimate concerns about a massive global crash when dated computer codes rolled to a new century.  However, years of preparation, and an enormous expenditure of time and money, eliminated any potential problems.  So let us be grateful for the people and institutions that have invested so much effort into making this a seamless transition, even as we make ourselves aware of the various potential implications of the change.

 

1According to a research paper cited in a March 2014 report from the Federal Reserve Bank of New York, LIBOR’s origination has been credited to a Greek banker by the name of Minos Zombanakis, who in 1969 arranged an $80 million syndicated loan from Manufacturers Hanover to the Shah of Iran based on the reported funding costs of a set of reference banks.

2A repurchase agreement (repo) is a financial transaction in which one party sells an asset to another party with a promise to repurchase the asset at a pre-specified later date. In general, repos aid secondary market liquidity for the cash markets (for example, U.S. Treasuries), allowing dealers to act as market makers in a very efficient manner.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

Past performance is not a reliable indicator of future results.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Glossary of Terms

An interest-rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter.

Libor is the average London interbank interest rate at which a selection of banks on the London money market are prepared to lend to one another. LIBOR comes in 7 maturities (from overnight to 12 months) and in 5 different currencies.

The secured overnight financing rate (SOFR) is a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (Libor).

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The information provided is for general informational purposes only. References to any specific securities, sectors or investment themes are for illustrative purposes only and should not be considered an individualized recommendation or personalized investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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