SUMMARY
- Over the past year, industry leaders and regulators have laid the foundation for markets to reference and build liquidity around SOFR and SONIA, two alternative reference rates to replace Libor when it is retired (as early as 2021).
- One of PIMCO’s largest concerns is how nonderivative legacy securities or loans will be handled; it is imperative that investors assess and manage the risks associated with legacy positions. Market participation in support of the alternative rate will help inform fair fallback methodologies.
- PIMCO as always is a voice on behalf of our clients, and we remain closely involved with regulators and industry groups to help manage the risks and shape the ongoing evolution away from Libor.
Investors and regulators worldwide are preparing for life after Libor. The predominant floating-rate benchmark index – which serves investors not only as a reference rate for a tremendous range of securities and derivatives worldwide but also as a signal for market liquidity and looming risks – may no longer be available in three years. The role it plays across global markets must then be taken up by one or more alternative reference rates. For American football enthusiasts, it’s akin to choosing and preparing a backup quarterback to take the leading role as a longtime veteran is about to retire.
The global banking community has agreed to continue to report Libor (which is short for London Interbank Offered Rate; the index is administered by the Intercontinental Exchange or ICE) until the end of 2021. Central banks and other public sector organizations are leading cooperative efforts with the private sector to identify alternative reference rates and develop transition plans.
Back in August 2017, we escalated our concerns regarding a lack of concrete plans for an alternative to Libor ( PIMCO Viewpoint, “No Room for Error” ). Establishing a fair and appropriate construct to transition legacy derivative contracts and cash products from Libor to its successor(s) presents many challenges. In the past year, however, we’ve seen encouraging regulatory and industry-sponsored developments and practical initiatives to support liquidity in alternative rates. It won’t be easy and many key risks remain, but we believe the players and strategies are now in place to transition markets beyond Libor.
Background: Libor and reference rates
Libor represents the average interest rate that a bank would be charged by other banks for an unsecured loan over a specified term in a specific currency. It is used in determining periodic interest payments for over $350 trillion globally in derivatives, futures, corporate bonds, mortgages and other financial products, according to ICE.
The market for pricing the underlying funding transactions represented by Libor is essentially nonexistent, and contributors to Libor often rely on “expert judgment” to estimate funding rates. Trust in this judgment is crucial to markets that rely on Libor, and that trust was shaken in 2012 when several banks were accused of manipulating it. In 2014, the Financial Stability Board (FSB) initiated efforts for global reform in reference rates, and in 2017 U.K. regulators announced their intention to phase out Libor by 2021 after a transition to a new reference rate (or rates).
At PIMCO, we believe that the banking community may continue to voluntarily support and publish a Libor rate beyond 2021, due to its widespread use. However, groundwork laid over the past year supports market liquidity growth in alternative reference rates. We expect that market participants who seek greater transparency will increase utilization of these alternative benchmark rates and reduce reliance on Libor given the concerns regarding the size and frequency of transactions in the underlying market.
SOFR and other alternatives to Libor: recent developments
Over the past year, industry leaders and regulators have articulated tangible steps to implement alternatives to Libor, laying the foundation for markets to reference and build liquidity around them.
Public-private working groups in each regional jurisdiction nominated alternative reference rates: overnight funding rates that reflect the majority of funding activity. In the U.K. the unsecured SONIA (Sterling Overnight Index Average) rate was selected; it already sees robust derivative liquidity and market pricing.
The U.S., after analysis by the ARRC (Alternative Reference Rates Committee) at the New York Fed, elected to “draft” a new benchmark – the Secured Overnight Financing Rate (SOFR) – as a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. The New York Fed commenced publishing the SOFR rate daily beginning on 3 April 2018, with the benchmark based upon data collected on over $700 billion in secured overnight repurchase (repo) transactions every day.
Similarly, alternative rates have been identified for Swiss and Japanese markets (among others) that are based on actual transactions, thus seeking to address the most troubling aspect of how the current Libor benchmark is set.
Since the launches of SONIA and SOFR, key market participants have bolstered the infrastructure to support derivative markets and increase transparency of market-based estimates of future reference rates (see Figure 1). The Chicago Mercantile Exchange (CME) launched futures based on the SOFR rate in May 2018, and central counterparties (CCPs) recently began accepting overnight index and basis swaps for clearing. The public sector has issued floating-rate notes referencing the alternative rates to further encourage use of the rates in the cash market: In June 2018, the European Investment Bank (EIB) issued a sterling-denominated floating-rate bond linked to SONIA, and in July 2018, Fannie Mae issued a $6 billion SOFR-linked floating-rate note debt transaction.
Continued issuance in notes that reference SOFR should help build market confidence and drive investor demand for hedging in derivative markets, providing the SOFR market the depth and reputation it needs to be regarded as a viable reference rate. We believe that for SOFR to be universally adopted (like Libor), issuers must quickly adopt and issue liabilities (notes) based upon these alternative benchmark rates. One way to encourage market acceptance is for issuers of short-dated instruments (money market tranches, for example) to issue inaugural SOFR-based instruments to test SOFR market pricing, increasing the issuance base while building market confidence.
The changing landscape for risks
With the development of robust alternatives to Libor underway, one of PIMCO’s largest concerns is the handling of nonderivative legacy securities or loans. These securities include agency adjustable-rate mortgages (ARMs), asset-backed securities (ABS), mortgage-backed securities such as collateralized mortgage obligations (CMOs), and collateralized debt obligations (CDOs) and corporate floating-rate notes (FRNs).
Proprietary PIMCO research finds that certain products and individual securities do not, in our view, provide adequate fallback provisions should Libor resets cease. Some other securities do articulate fallback provisions in their indentures that provide certainty of treatment, but may present the risk of a material change in the valuation or functioning of the securities as we approach the likely end of Libor in 2021. Specifically, some notes make the coupon equal to the last available Libor print, which effectively toggles the security in question from a floating- to a fixed-rate obligation.
Broadly speaking, we see four categories of fallback provisions in legacy contracts:
1) converting to a fixed-rate obligation by setting the floating rate equal to a rate available in the preceding period;
2) providing determination agent discretion to estimate Libor with comparable sources;
3) allowing the determination agent flexibility to switch to a successor or alternative rate and
4) not providing explicit detail on how the security will perform if Libor is not readily available.
Each of these presents potential disadvantages in addressing a permanent Libor discontinuation, but it is typically impractical (even impossible) to amend the legacy securities’ contracts. In most cases, investor consent is required to make changes that would have a material effect on any interest rate calculation. Although recent new issues have included disclosures highlighting the risks to Libor continuing in the future, they often provide expansive flexibility and discretion – leaving investors at the mercy of the issuer’s judgment.
Risk management and investor advocacy
We believe a proactive approach is key: It is imperative that investors assess and manage the risks associated with legacy positions, while having an eye on the future of SOFR. On behalf of our clients, PIMCO’s risk management, legal and portfolio management teams have undertaken a comprehensive review of existing portfolio holdings to uncover any legacy language that may impact market liquidity and valuations as we gradually transition from Libor to SOFR.
Furthermore, we suggest that investors proactively advocate for and collaborate with issuers, securitization firms and other members of the industry to propose replacement or fallback language for nonderivative contracts in order to reduce the risk of disruption when Libor is discontinued. The ARRC has established joint public-private working groups with the goal of reaching consensus on suggested fallback language. As agreement is reached across market participants in each cash product, we believe any issuance of new obligations must outline and adopt specific language that offers certainty to investors and limits discretion in a scenario where a fallback may be triggered in the future. Moreover, in order to ensure the efficacy of derivative hedges and reduce basis risk across products, the market should strive for consistency in fallback language where feasible and appropriate.
In the derivative markets, the International Swaps and Derivatives Association (ISDA) has launched a market consultation to collect feedback on the approach to amending the fallback provisions for new trades in swaps governed by the ubiquitous contract language. Any market participant may provide feedback on the approach for applying spread adjustments to account for the differences in methodology and terms between alternative rates and Libor. The consultation will collect responses through October 2018 and the resulting decisions on fallback provisions are expected to be included in new swap trades starting in 2019. The Fed’s paced transition plan for SOFR anticipates continued transition in cleared markets, which will provide for the creation of a term reference rate based on sufficiently liquid SOFR-benchmarked derivatives by the end of 2021. We expect that liquidity in derivatives referencing alternative rates will grow over the next year as the rates are utilized in wider contexts, which could increase hedging demands.
Advocacy will help shape the market environment after Libor: Over the next year, we expect that market participants also will be able to provide feedback on potential approaches to hardwiring fallbacks into security contracts. The ARRC will likely solicit market feedback on standardized fallback language for nonderivative products. It is crucial for a wide range of investors to participate in the discussion and debate of the various proposals. PIMCO as always is a voice on behalf of our clients, and we remain closely involved with regulators and industry groups who help manage the risks and shape the ongoing evolution away from Libor.
Key takeaways
PIMCO is supportive of market initiatives to establish alternative rates that are robust and representative of actual transactions. We expect that as the market develops, new issuance and derivative market participants will voluntarily transition to the alternative rate. Market participation in support of the alternative rate will help inform fair fallback methodologies that can step in when Libor is finally retired.
DISCLOSURES
Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as a recommendation for the purchase or sale of any financial instrument. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
Except for the historical information and discussions contained herein, statements contained in this viewpoint may constitute forward-looking statements. These statements may involve a number of risks, uncertainties and other factors that could cause actual results to differ materially, including the performance of financial markets, the performance of PIMCO's investment products, general economic conditions, competitive conditions and government regulations, including changes in securities regulations.. Further, such forward-looking statements speak only on the date at which such statements are made. PIMCO undertakes no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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