This week we note the end of Libor after a run of nearly 40 years. It’s a holiday-shortened week. Have a great weekend!
LIBOR is Dead--Well, Sort of.
June 30 marked the end of the road for LIBOR setting by the panel of global banks which since 1986 had produced daily estimates of the interest rates they would charge for inter-bank loans. At its height LIBOR was widely used as the reference rate for mortgages, floating rate commercial paper, corporate bonds, Federal agency securities, municipal debt and, not incidentally, interest rate swaps and all manner of other derivatives. The Federal Reserve estimated in 2021 that in excess of $200 trillion—that’s not a typo, $200 trillion!—of assets outstanding were linked to Libor. Most were derivatives, but bonds, including those issues by Federal agencies, corporations and municipalities totaled $1.1 trillion.
Public funds portfolios, including those of LGIPs, often purchased these securities, though the amounts are not known.
After the Great Recession regulators in the US and EU concluded that the rates set by the banks were subject to manipulation and began an effort to have Libor phased out. Yes, it took nearly 15 years—such is the pace of change in the financial markets.
In the US, Libor has been replaced by the Secured Overnight Financing Rate (SOFR) which is directly calculated from rates on overnight Treasury repurchase agreements. SOFR has the advantage of being derived directly from actual transactions rather than being set by judgement or, as regulators claimed, by agreement subject to manipulation.
Imagine that Libor rates came from a small group of bankers getting on the phone in London each morning and saying “whadda ya think we are charging today to lend?” SOFR comes from a computer that evaluates hundreds of overnight repurchase agreement transactions including those directly involving the Federal Reserve and prints a rate.
Early this week, in language that some might find reminiscent of Monty Python, the Financial Conduct Authority, the UK regulatory organization announced that “The overnight and 12-month US dollar LIBOR settings have now permanently ceased.”
This is not quite lights out. According to the FCA, ICE Benchmark Administration will continue for a time to post a calculated value for the 1- 3-and 6-month rates but the FCA noted that “these settings are now permanently unrepresentative of the underlying markets they previously sought to measure.”
Libor may be history, but floating rate securities remain a useful addition to short-term portfolios since the rates they pay may closely track underlying money market rates. If so, they help to keep a portfolio’s yield current with market changes, rising as broader interest rates rise and falling when market rates fall.
Floating rate securities, issued as commercial paper, negotiable certificates of deposit and Federal agency bonds, are now largely linked to SOFR and thus will closely follow the rates on overnight repurchase agreements and the Fed’s target Federal Funds rate.
The major rating agencies recognize that SOFR-based securities should closely track the market, and thus are consistent with criteria for a stable net asset value rating.
That is not to say that SOFR-based securities are risk free. They still rely on the ability of the issuer to make timely payments. If a corporate or bank issuer were to become insolvent the floating rate payments might be delayed or reduced. If so, the market value of the security would suffer, and this could drag down the market value of a portfolio holding these securities.
While the rate risk of a SOFR based security may be less than that of a security based on Libor—better to depend on a computer analysis of transactions than on a small group of bankers on the phone—the performance of these securities in an adverse market is yet to be fully tested.
SOFR is not designed to reflect the interest rate premium that investors require for corporate bonds, commercial paper and other credit instruments. This means floating rate corporate obligations linked to SOFR expose a portfolio to more price/value risk than those linked to Libor. More caution should be exercised when using these in portfolios such as stable net asset value LGIPs where there are narrow limits to the level of unrealized losses that can be sustained. Portfolio managers and LGIP boards should pay particular attention to the results of portfolio stress tests that simulate unfavorable interest rate, market movement and redemption events on a portfolio, and also carefully consider the average life of a portfolio (so-called "WAL") when calculated to the maturity of all securities rather than to the dates securities re-set as measures to assess and manage this risk.
SEC Money Market Reform Will Be Voted Next Wednesday. The Securities and Exchange Commission has scheduled a meeting July 12 to approve final regulations reforming—once again—the rules under which money market mutual funds operate. The proposed rules, published in 2021, were controversial and it will be interesting to see what, if any, modifications the Commission makes to address comments received from industry, academic and consumer groups. We’ll provide commentary once the Commission acts.
More on Bank consolidation. Last week’s Beyond the News brief noted that a new round of regulation and capital requirements for banks could lead to significant bank consolidation, changing the industry landscape. Bloomberg’s Matt Levine made a similar point in his column July 5 and the Wall Street Journal weighed in as well. Stay tuned.