Lost among the headlines of trade wars, decelerating global growth, and volatile stock indices, a transformation has been taking place in the overnight bank funding markets. The London Interbank Offered Rate (LIBOR), the globally referenced benchmark for interbank lending, is in the early stages of being phased out by UK regulators following a rate-setting scandal in 2012. While a new benchmark rate has yet to be broadly agreed upon, the Federal Reserve introduced a proposed replacement—the Secured Overnight Financing Rate (SOFR)—18 months ago with the intention of creating a new global benchmark for dollar-based funding. We believe SOFR will likely become the dominant benchmark rate in the future despite numerous challenges to its full implementation.
Since the mid-1980s, LIBOR has been used by companies and consumers to determine the cost of everything from student loans and mortgages to complex derivatives by acting as the point of reference in variable-rate financial agreements. It is calculated from a daily survey of more than 15 large banks that estimate the cost to borrow from each other on an unsecured basis.
Following allegations in recent years that some banks attempted to manipulate LIBOR reporting with the intent to profit or in an effort to mask deteriorating liquidity conditions during the financial crisis, Britain’s Financial Conduct Authority (FCA) announced in July 2017 that it will no longer support LIBOR after 2021 in favor of phasing it out for an alternative.
While consensus has yet to definitively settle on a single substitute, market participants must begin adjusting to the post-LIBOR landscape, as the implications are far-reaching. For example, all the bond indentures of existing LIBOR-linked securities that mature beyond 2021 must be revised to reference a new (still unknown) benchmark. In fact, it has been estimated that LIBOR is linked to over $350 trillion of financial products.1 Additionally, the indenture language for newly issued bonds that mature beyond 2021 must be flexible enough to accommodate whichever benchmark is chosen to supersede LIBOR. No small task indeed!
Following the LIBOR scandal (but before the FCA announced LIBOR’s discontinuation), the Federal Reserve Board and the New York Fed formed the Alternative Reference Rates Committee (ARRC), tasked with developing LIBOR’s U.S. replacement. In 2017, ARRC introduced SOFR as its proposed alternative to LIBOR.
In our view, SOFR appears to avoid some of the pitfalls that ultimately tainted LIBOR. SOFR is based on real transactions from many firms, such as broker-dealers, money market funds, asset managers and insurance companies. Additionally, it is a secured rate, as the repurchase agreement rates from which it is derived are backed by U.S. Treasury assets. In addition to architecting SOFR itself, ARRC also laid out a multi-step plan that included the creation and publication of rate information, setting up related futures trading, building out swap transactions tied to the new rate, and establishing SOFR’s indicative term structure.
Despite ARRC’s careful consideration, concerns exist about SOFR as a benchmark rate. Importantly, it will take time for enough liquidity to develop in the SOFR market to validate its reliability as a benchmark. Also, SOFR is a spot rate, making it potentially susceptible to large movements from day to day, and it has
often spiked at calendar quarter-ends when institutional borrowing tends to increase. In fact, just recently, SOFR experienced its largest jump to date—more than 300 basis points—due to Treasury settlements and a temporary corporate cash crunch.
Only after the Federal Reserve conducted three open market operations on sequential mornings did SOFR return to more normalized levels. Finally, SOFR only has a one-day tenor, whereas LIBOR has many different tenors. Without a term structure, there are challenges for both new financial instruments and existing longer-dated financial instruments that currently price off LIBOR. SOFR-linked pricing is most comparable to the effective fed funds rate, an overnight rate.
Includes bank credit risk
Nonetheless, given the impending demise of LIBOR, there has been an increase in the use of SOFR as a benchmark for floating-rate debt. In the cash bond market, Fannie Mae, the World Bank, and Credit Suisse were among the first to issue floating-rate notes (FRNs) based on SOFR. J.P. Morgan was the first money-center bank to issue a fixed-to-floating-rate preferred security that references SOFR. In the loan market, Fannie Mae and Freddie Mac have announced plans to develop new adjustable-rate mortgage products that would rely on SOFR instead of LIBOR. Currently, government- sponsored enterprises make up an overwhelming portion of SOFR-linked debt, accounting for roughly 80% of all SOFR FRN debt outstanding.2
Despite some of the initial challenges facing the SOFR rollout, we have been active buyers of SOFR-linked agency debt since October 2018. These securities currently provide a yield advantage over fixed-rate bonds with comparable maturities, as well as LIBOR-linked floating-rate debt. Additionally, agency SOFR FRNs have helped us avoid some of the uncertainty surrounding the LIBOR phase out, and the one- day resets have enabled us to enhance yield while managing the weighted average maturity of our clients’ portfolios.
Given its designation by ARRC as the recommended replacement, we believe SOFR is likely to become the dominant benchmark rate in the future. While 2021 may still seem distant, we expect the many challenges facing SOFR will be addressed in the months ahead, including potential tax, accounting, and regulatory hurdles. Accordingly, we will continue to closely monitor the transition to a new reference rate and take appropriate action in client portfolios as necessary.
BANK CAPITAL SECURITIES
Among term corporate bonds, domestic bank preferred securities, in particular, offer a unique challenge. These securities typically have a fixed-rate coupon for a “no- call” period (often five years) and then reset periodically after the no-call period to a floating rate using a floating rate benchmark (historically 3-month LIBOR plus a spread). To address the LIBOR phase-out, banks have begun issuing preferred securities that either (1) reset off of fixed-rate U.S. Treasuries (thereby avoiding the issue altogether); (2) continue to use LIBOR as the reference reset benchmark, but include recommended ARRC benchmark fallback language that ensures indentures honor LIBOR’s replacement; or (3) reset using SOFR, but also include benchmark fallback language that ensures indenture effectiveness post 2021. The use of different benchmarks for the reset introduces more complexity into an already complex debt instrument and requires a close read of the prospectus. While these instruments can offer attractive investment opportunities, they require extensive due diligence to analyze and fully understand the risks.
1ICE Benchmark Administration, “Roadmap for ICE LIBOR,” 18 March 2016, accessed through accessed through The Intercontinental Exchange website; https://www.theice.com/publicdocs/ICE_LIBOR_Roadmap0316.pdf
2Bloomberg, PNC Capital Advisors analysis
This publication is for informational purposes only. Information contained herein is believed to be accurate, but has not been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice or a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable.
© The PNC Financial Services Group, Inc. All rights reserved.
INVESTMENTS: NOT FDIC INSURED – NO BANK GUARANTEE – MAY LOSE VALUE