The UK Financial Services Authority (FSA) announced last week that it will phase out the London Interbank Offered Rate (Libor), which serves as the reference for many interest rate calculations around the world. The index is published daily by ICE Benchmark Administration for five currencies and seven maturities.
The FSA is planning to complete the process and to have a new benchmark rate in place by the end of 2021.
The reason for the move is the inherent flaw in the mechanism of fixing the daily rate, based on submissions by banks, which makes it vulnerable to manipulation. The extent to which the rate had been manipulated by the banks came to light in 2008, culminating in criminal investigations in 2012 and resulting in calls for a better solution.
Libor is predominantly used as a reference rate for floating-rate bonds, loans, mortgages, derivatives and other financial instruments. Fund managers use Libor in their performance benchmarks and hurdle rate calculations.
Bond impact
A report published by China’s ICBC points to a potential short-term impact on floating rate bond issuance. Libor’s replacement has not yet been determined – there are many alternative rates to choose from – and the uncertainty around which rate prevails can affect bond issuance, the report states.
For floating-rate bonds maturing after 2021, issuers will have to reneogtiate contracts with bondholders to adopt a new reference rate, creating temporary uncertainty until the new rate is chosen.
“While the potential for disruption is significant, a phase-out of Libor cannot be done without laying the proper framework for an alternative,” commented Jeff Bakalar, managing director and head of senior loans at Voya Investment Management, in an email to FSA. “As such, we don’t envision a material impact on the functioning of the global syndicated loan market.” Bakalar manages a portfolio of floating-rate syndicated loans tied to Libor.
“The potential shift is more problematic for larger, more vulnerable markets (e.g. retail mortgage, commercial real estate, derivatives) that will likely need to forge a solution that the loan market could and would adopt,” he added.
“The phase-out of Libor is a complex task,” noted Alex Zeeh, CEO of S.E.A. Asset Management. “The new index needs to be developed, it takes time to prove itself and to be accepted by market participants,” he told FSA. They will need to see not only the index methodology, but also the operational processes (“technicalities and piping” in Zeeh’s words) working in a robust way.
Total-return or market-neutral mutual funds, many of which use Libor as their benchmark, will need to amend their fund prospectuses to reflect a switch to a new index.
For Zeeh, whose firm manages the Asian High Yield Bond Fund, the main, but still minor, effect of the phase-out has to do with his funds’ performance fees. As the funds’ hurdle rates are tied to Libor, the funds’ prospectuses will have to be amended to replace it with an alternative rate. “It’s a minor technicality,” he said.
