- A massive transition is underway as the financial services industry works to replace LIBOR with alternative reference rates.
- The proposed end of LIBOR is year-end 2021, but it’s more realistic that LIBOR will slowly fade into the sunset, as opposed to just dropping off abruptly at the deadline.
- Our clients most likely have minimal direct exposure to this transition, but ripple effects through the financial markets are often unpredictable.
LIBOR, what is it good for?
Jon Schwartz, Senior Portfolio Manager
The London Inter-bank Offered Rate (LIBOR) has been no stranger to controversy, and many have been audibly wondering what it’s good for? The harshest critics might say “absolutely nothing.” Regardless, changes are afoot for this notorious benchmark rate. A change of this magnitude is complicated, but we are monitoring the transition and any potential ramifications for investors.
LIBOR, just to refresh, is the “reference rate” for various floating commercial and financial contracts, including corporate and municipal bonds, floating rate mortgages, asset-backed securities (ABS), consumer loans and interest rate swaps, and other derivatives. It is estimated that there are more than $200 trillion worth of financial products and securities tied to USD LIBOR.
Theoretically, LIBOR represents the rate a bank would have to pay to borrow money from another bank. In a properly functioning LIBOR market, the floating rate can be used as a barometer for the health of the banking system. Currently, LIBOR is determined with a survey of 11 to 18 large international banks, known as the ICE LIBOR panel. An average of the survey results is used to ultimately determine the LIBOR settings for various maturities in each of the five major currencies, including the US dollar, euro, pound sterling, Swiss franc and Japanese yen.
This survey system works only when confidentiality and anonymity of the LIBOR voters are preserved, but when you have an index that is so heavily influenced by just a few participants, the opportunity for bias in the submissions is unavoidable. When you get a few banks going one step further and actually colluding to manipulate their daily rate submissions for their own economic gain, you get a scandal. And that’s exactly what happened in 2008. The Wall Street Journal released a few articles in 2008 showing participating banks had understated their borrowing costs for many years leading up to the financial crisis. After many conclusive investigations and a few federal prosecutions, the process to replace LIBOR began.
Agents of change
With fallout from the LIBOR scandal came an influx of a few new acronyms all working together to replace the benchmark rate. The global benchmark will be taken over by a new Alternative Reference Rate (ARR). The Alternative Reference Rate Committee (ARRC) in the US has selected the Secured Overnight Financing Rate (SOFR) as the “replacement” for LIBOR. The ARRC will lead the transition from the LIBOR world to the SOFR world. The International Organization of Securities Commission (IOSCO) established a set of criteria that was necessary for a reliable LIBOR replacement. They determined that the benchmark index needed to be “anchored by observable transactions” and not be based on “expert judgment” by financial institutions. Given that SOFR would be based on the daily weighted average of centrally cleared repurchase agreement (repo) transactions that trade on a volume of more than $1 trillion per day, manipulation of the index would be virtually impossible.
With LIBOR’s replacement now established, it’s critical to understand the key differences between the old and the new:
LIBOR is an unsecured lending rate with various forward terms (1-month, 3-month, 12-month, etc.). The longer the term, the larger the credit risk implied by LIBOR. LIBOR is calculated and published by the ICE Benchmarking Administration. The bank submissions for the index are ultimately based on “expert judgment,” not observable transactions.
SOFR is a secured overnight lending rate with US Treasuries as collateral. The levels are established after observing transaction-level repo data and are published by the New York Federal Reserve. The transactions are historical, so clearly these are backward-looking funding levels. This is understood to be a risk-free, overnight borrowing rate, since the collateral is US Treasuries.
When considering the transition from LIBOR to SOFR, it’s important to understand that the greatest impact will be felt in the currently existing financial contracts that reference LIBOR now, as it will still be in existence after the end of the 2021 LIBOR transition date. Most floating rate products that have been issued since early 2018, and any that will be issued in the future, will reference LIBOR, but they will have fallback language written in the agreements to reference an alternative rate, in the event LIBOR goes away. In fact, some financial contracts already explicitly reference SOFR as the reference rate, but these securities are still in their infancy with minimal liquidity. As more participants enter the market supporting SOFR, the quicker the SOFR market can mature and potentially take over LIBOR in terms of trading volume.
The problem with a LIBOR transition is that without a deep and liquid futures market, participants will not be able to risk-manage with SOFR derivatives. Yet without a mature SOFR derivatives market, there will be no reason to develop and participate in a deep and liquid futures market. The proposed end of LIBOR is the end of 2021, but it’s more realistic to expect LIBOR to slowly fade into the sunset, as opposed to just dropping off abruptly at the proposed deadline. As the SOFR market matures, the market’s dependence on LIBOR should fade.
What does all this mean for our clients?
For the vast majority of our clients, this commotion is nothing to be concerned about.
At the bank level, SVB is keeping on top of the LIBOR transition and continues to monitor closely. It is business as usual for SVB bank products tied to LIBOR including syndicated loans, where fallback language has been adopted that allows the flexibility to change to an alternative rate should LIBOR no longer be available. From SVB Asset Management’s perspective, clients’ portfolios should be minimally impacted. There will be options for alternative rate indices and adjustments as needed to ensure a smooth Libor transition.
Outside of the bank, the large money center banks will warehouse the majority of the LIBOR-based derivative exposure. Combined with lenders in the commercial and business loan space, that covers 98 percent of notional tied to LIBOR. The Business Loans section is comprised of floating rate notes (FRNs), syndicated floating rate loans and collateralized loan obligations (CLOs). For most of the existing FRN population, which would include clients with LIBOR-based loans, existing fallback language within the legal documentation of the products should pave the way for a smooth transition to a LIBOR alternative. Already 90 percent of ABS reference SOFR or some other non-LIBOR alternative, with a small portion of credit card and student loan ABS still referencing LIBOR.
At the end of the day, we don’t really know exactly how this massive financial experiment of transitioning away from LIBOR will go. In fact, we don’t even know if LIBOR will ever go away entirely. While there is generally buy-in and support from all market participants for the replacement of LIBOR, success will hinge upon the big players’ commitment to rally behind SOFR. The good news is that our clients' investment portfolios have minimal direct exposure to this transition, but ripple effects through the financial markets are often unpredictable. So stay tuned!
Steve Johnson, CFA, Senior Portfolio Manager
Notwithstanding the late-month market volatility attributed to the emergence and spread of the coronavirus, the new year is off to an uneventful beginning. But from a Fed-watcher’s perspective, that’s probably a good thing. On the whole, the most recent economic data has been mixed and middle of the road — not too hot and not too cold. This offers a continuing solid backdrop for businesses while also giving the Fed cover to maintain its accommodative stance for the foreseeable future.
One theme we have been seeing is strength in the services sector and less robust data from manufacturing. In the US, the preliminary Purchasing Managers’ Index (PMI) readings for January declined 0.7 points to 51.7. This was lower than the 52.5 expected, even as the services gauge was higher than expected, logging its highest reading since March of last year.
December’s Non-Manufacturing ISM Report on Business, which is a purchasing survey of the US service economy, was 55, which surprised to the upside and exceeded the November reading of 53.9. The underlying details were mixed as business activity rebounded substantially, though forward-looking components and employment figures declined.
Along with strength in the services sector, the stout US consumers continue to do their part to keep the economy humming. Retail sales surprised to the upside in December, rising 0.3 percent month-over-month. Excluding autos and gas, retail sales were slightly better, rising 0.5 percent month-over-month, though corresponding November figures were revised lower. Within the report, the details were largely upbeat, with increases in 12 of the 13 major retailer categories. Notably, the eating/drinking out category rebounded and increased by 0.2 percent month-over-month in December, after two consecutive monthly declines.
Given this strong consumer activity, it’s no surprise that the consumer confidence index (CCI) improved to 131.6 in January from an upwardly revised 128.2 in December. This jump was higher than the consensus estimate, perhaps reflecting more optimism for a lasting trade deal with China. After the escalation of the trade war in August, the index fell significantly. However, with the signing of the Phase One trade deal, it appears that consumers are less worried than they were in late summer and early fall.
Other data points were largely mixed. The employment picture remains relatively encouraging, even as US payrolls came in somewhat below expectations, with 145,000 new jobs created in December vs. consensus estimates of 160,000. The three-month average now stands at 184,000 new payrolls. And while that’s lower than the six-month average, it still keeps the impressive job-creation streak alive. Average hourly earnings, however, increased only nominally by 0.11 percent month-over-month. This dropped the year-over-year growth to just 2.87 percent, its lowest level since July of 2018, whereas the overall unemployment rate remained unchanged at 3.5 percent.
Perhaps more troubling than the job picture was a decline in new home sales, which dropped 0.4 percent month-over-month to a seasonally adjusted annual rate of 694,000. This now marks three consecutive months of decline, though December’s figure is still 1.8 percent above the 2019 average.
So how has all this mixed data translated into inflation and, ultimately, overall economic growth? The Fed’s preferred inflation measure, the personal consumption expenditures (PCE) price index, excluding food and energy, rose at an annual rate of 1.6 percent during December. This remains relatively tepid and within broad expectations but below the stated target of 2.0 percent. Meanwhile, the advance estimate for fourth-quarter GDP was 2.1 percent, which brings the estimated 2019 full-year GDP growth to 2.3 percent. All this reinforces why we believe the Fed remains on hold with its current policy until data shifts materially.
Tim Lee, CFA, Senior Credit Risk & Research Officer
Fitness fanatics are not the only ones who appreciate strong abs. Investors are, once again, paying attention to asset-backed securities (ABS), thanks to their understated credit strength that looks like it will continue into 2020. In particular, ABS collateralized by consumer obligations — such as prime quality auto loans and leases, credit card receivables and mobile phone payments — have exhibited delinquency and default rates that have been below rating agency base case expectations. As a result, there were no downgrades of any senior Aaa-rated ABS security collateralized by the aforementioned consumer obligations in 2019. This was also the case in 2018, according to Moody’s data. In fact, when accounting for both investment grade and noninvestment grade-rated auto, credit card, and phone payment for collateralized ABS issued in the US, there were 841 upgrade actions vs. one downgrade action and no defaults since the beginning of 2018.
A solid labor market has been the primary driver of the robust credit performance, with the unemployment rate ending 2019 at 3.5 percent, which is just shy of the 3.4 percent all-time low rate achieved under President Lyndon Johnson in 1968. Job creation remains at constructive levels, despite a pace that is off record levels. With job openings outstripping the number of unemployed workers and rising wages, tight labor conditions look to continue through 2020. Even if and when the labor market moderates, consumers should be able to comfortably continue making their monthly payments.
Such timely payments supported strong underlying credit performance in consumer ABS collateral at the start of the year. For credit card collateral, payment rates and excess spread were near record highs, while charge-offs were near historic lows, based on J.P. Morgan indices. Annualized net losses for prime auto loans backing ABS stood at a healthy 0.57 percent, while residual values on auto leases were positive due to resilient used car pricing, according to Fitch ratings indices. With underwriting standards generally stable and muted net loss levels that are far from expected default levels, many Aaa-rated consumer ABS have been left considerably fortified to handle any potential future problems. We expect strong credit protection levels to help extend the streak of Aaa-rated consumer ABS securities, avoiding any negative rating agency action through 2020. Of course, we aim to exercise good judgment in any ABS investments, as always.
Hiroshi Ikemoto, Fixed Income Trader
Bond markets have largely moved in one direction to start the year, as a redeployment of year-end cash and a recent flight to quality have grinded credit spreads and all-in yields lower. The latest rally, covering the end of January, largely centered on concerns surrounding the coronavirus and its potential negative economic effects on global growth. The benchmark two-year Treasury note yield rallied to as low as 1.38 percent — the lowest since October 2019 — while investors sought safe havens as uncertainties mounted. In addition, with the Federal Reserve staying the course and avoiding any surprises in the January Federal Open Market Committee (FOMC) meeting, global geopolitical and economic risks remain near-term drivers of market sentiment.
In the corporate bond market, credit spreads have compressed 5 basis points (bps), with all-in yields lower by 15 bps as both benchmark Treasuries and the Euro Dollar Synthetic Forward (EDSF) curve rallied. Tighter spreads and lower overall inventory reflect the strong demand for high-quality bonds, as buyers search for some yield pickup to Treasuries. Commercial paper rates dropped as both 1-month and 3-month LIBOR indexes, which are used to price the security type, rallied more than 10 bps month-to-date. Investor focus has remained on the front end of the curve, particularly as yield curves remain flat and volatility is expected to persist.
Despite market yields largely moving lower across products, repurchase agreements (repos) have remained a steady performer with little to no change through January. And as a result of the widely expected Fed decision to boost interest on excess reserves (IOER), repo yields actually increased as the month drew to a close. We expect these rates to remain steady as the Fed continues its repo operations both in overnight and term through April. This Fed intervention has calmed the money markets for the moment. Repo remains a potentially attractive overnight investment for clients looking for additional return over money market funds. As we have continued our strategy of keeping the average duration of portfolios neutral-to-long to our targeted benchmarks, the accounts have benefitted by locking in higher yields in this current risk-off environment. Of course, we remain disciplined in our strategy of balancing duration, investing in high-quality credit and maintaining liquidity in an ever-evolving market.
|Treasury Rates:||Total Returns:|
|3-Month||1.54%||ML 3-Month Treasury||0.13%|
|6-Month||1.52%||ML 6-Month Treasury||0.15%|
|1-Year||1.42%||ML 12-Month Treasury||0.24%|
Source: Bloomberg, Silicon Valley Bank as of 01/31/20
This article was updated on February 24, 2020 to reflect SVB and SVB Asset Management perspectives.
SVB Asset Management's monthly Market Insights covers current topics on portfolio management, credit considerations and market events that influence corporate investment strategy.
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