Libor fallbacks a low priority for most bond investors

Many asset managers are continuing to buy securities linked to the discredited benchmark rate Libor, while ignoring poor fallback provisions that would apply if the widely used rate ceased after 2021, investors and industry advisers say.

By holding cash products with conflicting or sometimes absent legal backstops, investors may be storing up risks in their portfolios, with bonds switching to unwanted rates or mired in lawsuits, sources warn.

One investment advisor reports little industry engagement on benchmark transition. “Our internal conversations on the replacement of Libor have been few and far between. We don’t see a tremendous sense of urgency right now,” says Will Goldthwait, a portfolio strategist at State Street Global Advisors, adding that he expects investor attention to heighten next year.

A review of floating rate issuances from August 2017 to June 2018 conducted by Covenant Review, a bond and loan analytics service, showed that nearly half of the 102 notes examined do not have so-called fallback language that would specify an alternative reference rate in the event that banks stop quoting Libor. Instead, they take the last quoted Libor rate for the remaining life of the bond, effectively converting it into a fixed rate instrument.

Floating rate cash products issued more recently have included clearer language setting out a process to move bonds off Libor should the rate cease. But this language can vary by issuer, creating potentially meaningful differences between similar securities.

Many investors have shrugged off these concerns, buying the securities regardless. Eric Bernstein, head of investment management at financial technology firm Broadridge Financial Solutions, estimates that fewer than 25% of investors currently refrain from buying Libor-linked bonds because of what they see as poor fallback language. Speaking in February, a US-based structured securities investor said they had only heard of one investor avoiding Libor-related securities.

“We haven’t taken any hard decisions to say we’re going to avoid this or not invest in anything further, or to say we’ll hang on to what we have and not sell anything. We’ve been taking it on faith that somebody’s going to get this thing worked out,” the investor said.

Industry-led working groups are developing legal language to insert into new and legacy swap contracts that allows them to convert to an alternative rate should Libor cease after the end of 2021, when the UK Financial Conduct Authority gives up its power to compel banks to submit quotes to the benchmark administrator. Working groups are working on similar language for the cash market, but it has yet to be finalised.

The differences in language between issuers can be small but important. For instance, a clause in HSBC’s $500 million, six-year floating rate note issued on March 11 says the issuer will appoint an independent financial adviser to determine what the alternative rate should be. It says this rate will be “the rate that has replaced Libor in customary market usage for determining floating interest rates in respect of bonds denominated in US dollars”.

A similar provision in Barclays’ $750 million, five-year floating rate note issued on November 15 also says the bank will appoint an IFA in that situation, but it specifies that if the new rate requires a spread to be added to match the level of Libor, this should be one formally recommended by the Federal Reserve, the UK Financial Conduct Authority or the relevant industry working group.

Until it’s clear what the alternative rates actually are and how they’ll be used, it’s hard for [investors] to begin making operational and investment changes

Eric Juzenas, Chatham Financial

The differences are important to some. One UK liability-driven investment trader, unhappy with a corporate bond’s provision to turn to an independent adviser if banks were to stop quoting Libor, decided not to invest, citing the “wide range of outcomes” that could result from the use of an IFA. For instance, he says the adviser could potentially adopt no spread adjustment, or leave it to reference the last available Libor rate, turning the bond into a fixed rate instrument.

The language also did not require the IFA to take note of decisions made by industry working groups when choosing the alternative rate or spread methodology. The trader says this could increase the potential for bondholders to head to the courts if the changes are disadvantageous to them.

Investors looking to avoid Libor-linked cash products have few options, analysts say, given the paucity of alternative products. The US, for example, has nominated SOFR as its replacement rate for Libor, but only 72 notes referencing the rate, amounting to just over $80 billion, had been issued by March 28. In other jurisdictions, there is less clarity on what the alternative rate will be.

“Until it’s clear what the alternative rates actually are and how they’ll be used, it’s hard for [investors] to begin making operational and investment changes,” says Eric Juzenas, director of the global regulatory solutions team at US-based Chatham Financial.

Juzenas believes it is too early for investors to make wholesale changes to portfolios. But he says individuals should familiarise themselves with proposed fallback provisions to understand whether the language offers suitable protection in the event that reference rates switch from Libor in future.

Editing by Alex Krohn