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Securitized Blog published on September 21, 2018

What to Know about the Libor Phaseout

On September 20, Triborough Bridge & Tunnel priced a remarketed $107 million worth of bonds that were originally part of a deal nearly two decades ago. Back then, the bonds were pegged to the London Interbank Offered Rate, or Libor, which is the reference short-term borrowing interest rate that is widely used in today’s fixed income markets. The new Triborough bonds, however, are pegged to the Secured Overnight Financing Rate, or SOFR.1 This matters because Triborough is the first municipal bond to be pegged to SOFR, marking another important step toward the phaseout of Libor as the market’s accepted short-term reference rate.

Understanding Libor

Libor is the interbank lending rate for U.S. dollars outside the U.S. It is the benchmark rate for the vast majority of adjustable-rate mortgages, student loans and auto loans. Securitized products, leveraged loans and municipal bonds are just a few of the typical assets with pricing that is pegged to Libor. About $350 trillion in securities are tied to Libor, per the Intercontinental Exchange (ICE).

Libor is an indicative short-term interest rate that is administered by the ICE. A panel of large international banks is polled to find the rate at which each bank could borrow U.S. dollars in the interbank market outside the U.S.

The index has had its share of negative attention in recent years, largely because it is not based on actual transactions. Rather, Libor rates are based on where banks think they can borrow, and some bad actors have faced criminal charges due to manipulation of the index.2 Partly for this reason, Libor is scheduled to be phased out, as the U.K.’s Financial Conduct Authority announced that it will not compel banks to provide quotes for Libor after year-end 2021.

Libor will likely be replaced by SOFR, per a plan created by the Alternative Reference Rates Committee (ARRC).3 SOFR, which first traded in May 2018, is the combination of three overnight Treasury repo rates. SOFR valuation is based on an enormous pool of underlying transactions – about $700 billion in daily trading – and is therefore less prone to manipulation.

Today’s investors should know the following about Libor replacement:

  • It could impact all fixed income markets, including corporate, municipal and securitized.
  • The fixed income markets could take several years to broadly accept SOFR as the Libor replacement. In addition, the Financial Accounting Standards Board will need to designate SOFR as a benchmark interest rate in the U.S.4
  • On the trading side, liquidity will need to develop in SOFR futures contracts. With a liquid futures market, a SOFR swap curve can be extrapolated into time and used for hedging SOFR-based assets and liabilities.
  • As initial signs of SOFR acceptance in the market, Fannie Mae, the World Bank and MetLife Inc. have recently issued SOFR-based floating-rate notes, which have been met with strong investor demand. In addition, Triborough indicates the “phasein” of SOFR for municipal bonds.
    • MetLife Inc. (Aa3/AA-) $1 billion 2-year floating rate notes, sold at SOFR + 57 basis points (bps).
    • Fannie Mae (Aaa/AA+) $6 billion 3-tranche floating rate notes; $2.5 billion 6-month maturity at SOFR + 8bps; $2.0 billion 12-month maturity at SOFR + 12bps; $1.5 billion 18-month maturity at SOFR + 16bps.
    • World Bank (Aaa/AAA) $1 billion 2-year floating rate notes, sold at SOFR + 22bps.
  • We expect that the change in the benchmark will require significant operational and legal work. The Bank of International Settlements (“BIS”) estimates there are hundreds of trillions of dollars of interest rate derivative contracts that reference Libor. It will be a significant burden on legal resources to have these contracts reworked.

Despite the hurdles in the transition away from Libor, we note that SOFR is transaction-based, which addresses the issue that Libor is an estimate from banks and is not based on actual trades. This could improve stability and reliability for SOFR-based transactions. As the replacement of Libor moves forward, Breckinridge is monitoring the situation for any potential unknown risks.

 

[1] Triborough Bridge & Tunnel (Aa3/AA-) was priced at 67% of SOFR +45-50 basis points to a mandatory tender on 9/26/19. SOFR reset at 1.92% on September 19, 2018.

[2] Chad Bray, “Two Former Barclays Traders Acquitted in Libor Retrial,” The New York Times, April 6, 2017.

[3] In 2014, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee to identify best practices for alternative reference rates, identify best practices for contract robustness, develop an adoption plan and create an implementation plan with metrics of success and a timeline.

[4] Per FASB, as of September 7, 2018: In the United States, only the interest rates on direct Treasury obligations of the U.S. government and, for practical reasons, the Libor swap rate and the Fed Funds Effective Rate (also referred to as the Overnight Index Swap Rate) are considered to be benchmark interest rates. The SIFMA Municipal Swap Rate is pending as a benchmark interest rate as well. 

 

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