- Libor (the London Interbank Offered Rate), the world’s most widely used benchmark for floating rate instruments, is transitioning to more robust benchmarks by the end of December 2021.
- USD Libor is being superseded by SOFR—the Secured Overnight Financing Rate. There are also planned replacements in other currencies. This transition is important to front-end investors because many liquidity strategies invest in floaters.
- While this change has its challenges, SOFR-based bonds and derivatives are already available in limited but growing volumes. J.P. Morgan Global Liquidity has been buying SOFR-based floaters since 2018 and is experienced in pricing, trading and settling these securities.
Libor is currently in the process of being phased out and replaced. The authorities responsible for Libor have said they cannot guarantee its publication beyond 2021. Below are some frequently asked questions that may be relevant to liquidity investors about the Libor transition and what comes next.
What is Libor?
Libor, the London Interbank Offered Rate, is intended to represent the rate at which banks can fund themselves on a short-term, unsecured basis in the London wholesale market. It has been the most widely used interest rate benchmark in the world.1 Libor is determined by a bank survey administered by the Intercontinental Exchange (ICE). Every business day, ICE asks a panel of about a dozen contributing banks the rate at which they can fund themselves in various tenors inside one year in five currencies: the Swiss franc (CHF), euro (EUR), pound (GBP), yen (JPY) and U.S. dollar (USD). ICE then collates the results, omits the top 25% and bottom 25% of submissions, and averages the middle to determine Libor.
Why has Libor been important for liquidity investors?
A floating-rate bond is an investment that pays regularly timed coupons that reset floating-rate bond is an investment that pays regularly timed coupons that reset periodically with prevailing interest rates, and pays principal at maturity. If interest rates rise, coupons rise; if interest rates fall, coupons fall. Because of their low duration, floating-rate bonds are frequently purchased by many money market and ultrashort strategies. Currently, Libor is the most common index rate used to reset floating-rate coupons.
What else is Libor used for?
Libor is used to, among other things, set the payments of the floating-rate legs of derivatives trades, as well as the interest rates on floating-rate mortgages, bank loans and deposits.
Why is Libor going away?
There are concerns about the robustness and sustainability of the process used to set Libor. The size of the interbank lending market is typically less than $1 billion a day.2 By contrast, the size of the market that uses Libor resets exceeds $200 trillion.3 The relatively small size of the London interbank lending market, the reduced number of banks participating in the Libor-setting process and the fact that Libor is set by a survey and not transactional data have led regulators to support the development of a more robust benchmark rate.
Who is in charge of the transition process away from Libor for USD-denominated instruments?
The Alternative Reference Rates Committee (ARRC) is overseeing the transition. The ARRC is a group of market participants initially convened by the Federal Reserve (Fed), in cooperation with the U.S. Treasury Department, the U.S. Commodity Futures Trading Commission and the U.S. Office of Financial Research.4 The ARRC first met in December 2014.
What is replacing Libor for USD-denominated instruments?
In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the replacement for USD Libor. SOFR is the overnight rate at which repurchase agreements (repos) collateralized by Treasuries are executed in the marketplace. The size of the Treasury repo market is approximately $1 trillion in transactions a day on average.5 Repurchase agreements are the main financing channel for Treasuries held on bank balance sheets. Therefore, SOFR is considered a good representation of the health and liquidity of the bank funding markets.
Who produces and administers SOFR?
The New York Fed publishes SOFR on its website on a daily basis, at approximately 8 a.m. EST. An internal New York Fed Oversight Committee reviews the rate production process from time to time.6
When is Libor going away?
Newly originated derivatives with floating legs are planned to transition to SOFR in the fall of 2020. Non-derivative instruments are scheduled to transition to SOFR by the end of 2021. However, SOFR-based derivatives and bonds are currently available in limited amounts, and volumes are growing. Money market funds have been significant buyers of SOFR floating-rate securities (floaters) issued by government-sponsored enterprises (GSEs) and are one of the drivers of the volume growth in that market.
What are the main differences between Libor and SOFR?
Libor determinations are for specific terms: overnight, one week, one month, two months, three months, six months and 12 months. SOFR is an overnight rate. Also, Libor is an unsecured funding rate, while SOFR is a secured funding rate. Furthermore, Libor is based on a survey and SOFR on transaction prices (Exhibit 1).
EXHIBIT 1: DIFFERENCES BETWEEN SOFR AND LIBOR7
If SOFR is an overnight rate, how will it set monthly or quarterly to pay floating-rate coupons?
Eventually, we believe, a derivatives market will develop from which market participants will be able to determine term SOFR rates. Until that time, monthly or quarterly pay coupons based on SOFR rates will likely be calculated by either compounding or averaging SOFR in arrears over the appropriate term.
Libor is an unsecured rate and SOFR is a secured rate. How will that affect bond spreads?
Theoretically, unsecured funding rates are higher risk and should be higher in yield. Therefore, all else being equal, the spread to SOFR should be wider than the spread to Libor for the same issuer to get an equivalent coupon.
What are the main challenges of the transition?
Liquidity is evolving for SOFR-based securities. SOFR bonds are liquid, but bid-offer spreads are currently slightly wider on SOFR-based floating-rate securities than on Libor-based bonds. We think bid-offer spreads should tighten in 2020 on a relative basis as the volume of issuance increases, derivatives markets develop and market participants become more familiar with SOFR.
Another challenge is determining what to do with older floating-rate securities that will remain outstanding beyond 2021 and whose underlying documents did not anticipate significant changes to the Libor fixing process. For these, the investment decision will depend on a number of factors, which may include but are not limited to: ease of making amendments to the underlying security documentation, liquidity, premium or discount to SOFR-equivalent securities, relative value and how the coupon is determined (or is expected to be determined) after the transition away from Libor.
New deals that have Libor resets in 2022 and beyond now often have fallback language that dictates how new floating payments will be calculated after the transition away from Libor. The generic elements of the fallback language are (1) a trigger event that defines the circumstances under which Libor will be replaced, (2) a replacement rate that will be used instead of Libor following the trigger event and (3) a spread adjustment, if necessary, that will account for the differences between the replacement rate and Libor.8 One of the challenges is how to value these securities when their earlier coupons paid based on Libor and their later coupons will pay based on SOFR.
Are any other index rates being changed as part of this regulatory initiative?
The transition away from Libor is a global initiative. Exhibit 2 outlines the alternative reference rates that have been selected in each Libor currency:
EXHIBIT 2: ALTERNATIVE REFERENCE RATES CHOSEN TO REPLACE LIBOR IN THE FIVE LIBOR CURRENCIES9
How is Libor reform affecting Global Liquidity strategies?
J.P. Morgan Global Liquidity has been a buyer of SOFR floaters since 2018. We have significant experience in the trading, settlement, fund accounting and pricing of securities using this index.
For money market fund portfolios, there is little that needs to be done differently today. Because money market fund regulations generally limit final maturities to 13 months, at present, any Libor holdings will mature well before the transition date of December 31, 2021. The only exceptions to the 13-month limit are U.S. Treasury floating-rate notes and government-sponsored enterprise floaters (both of which may be purchased out to two-year maturities under U.S. money market fund regulations). U.S. Treasury floater coupons currently reset based not on Libor but on the 3-month U.S. Treasury bill rate so they will not be directly affected when Libor goes away. As for new-issue Libor-based GSE floaters with resets after the end of 2021, we have not been purchasing these instruments. Finally, we note that the coupon calculations of U.S. Treasury floaters and GSE floaters that currently use, or will use, SOFR (or other Libor replacement index rates) will not be directly affected when Libor goes away.
In our ultrashort portfolios, we have reduced our exposure to Libor floaters that have resets beyond 2021. For longer-dated floaters, we prefer investments with SOFR resets.
1 “Frequently Asked Questions,” ARRC, SEC, https://www.sec.gov/spotlight/fixed-income-advisory-committee/arrc-faqs-041519.pdf
2 “LIBOR/SOFR FAQ,” Federal Home Loan Bank of San Francisco, http://www.fhlbsf.com/member/libor-transition-faq.aspx
3 “Transition from LIBOR,” ARRC, Federal Reserve Bank of New York, https://www.newyorkfed.org/arrc/sofr-transition
4 “Frequently Asked Questions,” ARRC, Federal Reserve Bank of New York, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf
5 “SOFR Primer: The transition away from LIBOR,” SIFMA, https://www.sifma.org/resources/research/sofr-primer/
6 “Transition from LIBOR,” ARRC Convened by Federal Reserve Board and Federal Reserve Bank of New York, https://www.newyorkfed.org/arrc/sofr-transition
7 Source: SIFMA. “SOFR Primer: The transition away from LIBOR,” SIFMA, July15, 2019, https://www.sifma.org/resources/research/sofr-primer/
8 “Summary of ARRC’s LIBOR Fallback Language,” Alternative Reference Rates Committee, New York Fed, November 2019, https://www.newyorkfed.org/medialibrary/ Microsites/arrc/files/2019/LIBOR_Fallback_Language_Summary.pdf
9 Source: New York Fed. “Frequently Asked Questions,” Alternative Reference Rates Committee, New York Federal Reserve, September 19, 2019, https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf