March 2023 / GLOBAL FIXED INCOME
Financial Authority Plans to Replace LIBOR Are Nearing Completion
Update on the USD LIBOR transition from T. Rowe Price.
- Financial authorities aim to complete their replacement of the USD London Interbank Offered Rate (LIBOR) with new alternative reference rates (ARRs) by mid‑2023.
- For U.S. dollar‑denominated assets, the alternative reference rate that is set to replace LIBOR is the Secured Overnight Financing Rate.
- T. Rowe Price’s dedicated working group has completed its exposure analysis and firmwide transition plans with the aim of minimizing any disruption to our clients’ investments.
The Financial Conduct Authority (FCA) first announced its intention to end the London Interbank Offered Rate (LIBOR) in July 2017. Since then, T. Rowe Price has monitored the situation closely as we formulated our strategy for managing the transition. In November 2019, our working group produced an article on the topic, explaining that the decline in interbank borrowing and reduced trust created the need for a new benchmark rate for a wide array of financial products. Later, in June 2020, we highlighted five important changes expected to result from the cessation of LIBOR, including proposed new alternative reference rates (ARRs) in each key market, and we subsequently revised this information in June 2021.
In this latest article, we provide a further update for clients as we approach the conclusion of the LIBOR transition process.
What Is Replacing USD LIBOR?
In the U.S., the planned ARR for dollar‑denominated assets is the Secured Overnight Financing Rate (SOFR), which is based on overnight loans in the U.S. Treasury repurchase (repo) market. The Alternative Reference Rate Committee (ARRC), a group of market participants convened by the Federal Reserve System and the Federal Reserve Bank of New York, has been leading the plans for the switch to SOFR.
The U.S. remains the last market to fully transition from LIBOR to the new ARR. Coming into effect at the end of 2021, the UK market switched to using the Sterling Overnight Indexed Average (SONIA) as the LIBOR replacement, while the Euro Short‑Term Rate (ESTER) was adopted in the eurozone. Elsewhere, the Swiss Average Rate Overnight (SARON) rate is now being used for Swiss francs, and the Tokyo Overnight Average Rate (TONA) for the Japanese yen.
What Is the Impact on Different Asset Classes to Date?
Regulators, such as the Federal Reserve and the FCA, strongly discouraged any new LIBOR issuance after the end of 2021. As a result, overall exposure in the markets is declining.
More broadly, a lot of attention in the transition plan has been devoted to “tough legacy” instruments—securities where governing documents do not establish clear fallbacks1 in the event of a permanent cessation of LIBOR and that are also difficult to amend to incorporate fallbacks1 In the U.S., Congress enacted the LIBOR Act to provide a uniform, nationwide solution for tough legacy contracts. The LIBOR Act and the implementing regulations by the Federal Reserve have helped to alleviate this concern.
Leveraged loans: Recent loan documentation incorporates language developed by the Loan Syndications and Trading Association (LSTA) and other trade groups that incorporate ARRC‑recommended fallback language. Many leveraged loans also typically include built‑in alternative rates, which may apply if LIBOR cannot be determined. However, these rates are often not appropriate as permanent LIBOR replacements. Because of these alternatives to LIBOR in the contracts, such instruments would be out of scope of the above‑mentioned legislation as they already contain fallbacks that are not based on LIBOR. Administrators of the leveraged loans will be working throughout the remaining period prior to June 2023 to amend loans and remove references to LIBOR for many of the loans. The ARRC messaged the market that the industry should “take action now to remediate contracts” prior to June 30, 2023.
Floating rate notes and asset‑backed securities: Existing floating rate notes (FRN) and asset‑backed securities (ABS) represent a challenge as they often require the consent of all holders to change the underlying benchmark interest rates. In addition, the power to initiate such amendments typically lies squarely with the issuers and not the bondholders. Therefore, these bonds should benefit from the aforementioned LIBOR Act. Meanwhile, new FRN bond issues priced after the end of 2021 are only referencing the new ARR directly.
Certain derivatives: The market has been generating a liquid derivatives market for hedging exposures to the new ARR. The International Swaps and Derivatives Association (ISDA) protocol to incorporate the fallbacks into existing contracts has been open for adherence since January 2021 with wide acceptance by market participants.
Have the Previous Challenges Regarding the Depth of Derivatives Markets and the Creation of SOFR Term Rates Been Overcome?
The ARRC has shown that activity data from cash and derivatives markets have been building at a strong, sustained pace. They noted that SOFR futures and options experienced strong growth during 2022. Average daily volumes and peak open interest for SOFR futures increased by several multiples compared with 2021, while average daily values and peak open interest for SOFR options increased by well over several thousand multiples, year over year.
Term SOFR was studied due to its merits for issuers’ calculation of interest due. The ARRC created a task force and, in conjunction with FSB and FSOC input, recommended that term SOFR remains limited in its usage but is open to continued assessment of its use.
What Is T. Rowe Price Doing to Prepare for the Transition?
Our primary aim is to keep any disruption to our clients’ investments to a minimum. To this end, T. Rowe Price’s dedicated working group, consisting of senior members from across the firm’s business units, is focusing on the following:
Planning for a Smooth Transition
Focusing on four key areas
LIBOR exposure analysis
Work has been completed to determine the extent of exposures to investments referencing LIBOR or other interbank offered rates across all T. Rowe Price‑managed portfolios.
We have reviewed all legal agreements on investments in LIBOR‑referencing securities. This information is helping us gauge how a change in the underlying interest rate will impact our client portfolios, down to the level of individual holdings.
In addition to our in‑house analysis, we contracted outside legal counsel to provide a third‑party assessment of T. Rowe Price’s exposure and potential risks for certain securities.
We continue to update our exposure numbers to account for potential transactions of LIBOR‑based securities in the secondary market and reduce exposure when leveraged loans are amended to eliminate LIBOR language.
Our main priority is to pursue the best outcome for our clients during the transition, while also minimizing potential disruption to their long‑term investments under the new ARR. On the derivatives side, T. Rowe Price has adhered to the ISDA LIBOR protocol. As a result, any current derivatives exposures that are outstanding at the transition date should benefit from clear fallback provisions.
We continue to monitor and leverage industry activity, as well as industry regulatory bodies, to help ensure a smooth transition.
Firmwide business and technology impact
An enterprise‑wide impact assessment was performed that included operations, technology, and arrangements with third parties. The impact assessment was then used to create an implementation plan that has been used to guide the project.
Communication and engagement with internal and external partners are key. Our working group is directing external communications with investors, as well as other market participants, to ensure transparency about the process and the timing of the transition. The group is in frequent contact with regulators to stay informed about the formulation of the ARR and other industry changes precipitated by LIBOR cessation.
The transition represents significant change, and with change comes uncertainty. However, T. Rowe Price has dedicated resources and an action plan in place to help ensure that client portfolios are well positioned to adjust to changes arising from the replacement of LIBOR.
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