SOFR, so Good! Transitioning away from LIBOR

Libor has historically been used for different purposes: as a benchmark rate for (nearly all) derivative instruments, and for cash bonds with specific features such as floating rate notes and asset backed securities. In terms of derivative markets and cash bonds, we do not expect much disruption from the shift away from Libor to other money market rates.

Most of the subordinated debt that has been issued by banks in the past few years contains fallback language in the prospectus that makes the determination of a new floating rate the responsibility of the payment agent or the issuer. In the primary market for sub debt, Angel Oak has recently been requiring additional language that allows the rate selected by the payment agent or issuer to be overridden if deemed inappropriate by most investors. In almost all instances, the fallback language allows a spread to be added to the replacement rate to ensure that it is adjusted to be equal to the prevailing LIBOR-based coupon on the date that any new rate becomes effective. This should ensure that there are no discontinuities in the rates paid to investors after the change.

We are closely monitoring the transition away from LIBOR since some preferred securities have LIBOR-based floating rate formulas. However, the preferred market is only one of many that will be impacted by the end of LIBOR. While the end of LIBOR is more than two years away, a solution is necessary (and expected) for a broad array of products. Ultimately, we are still in wait-and-see mode, but we remain confident that our market will settle on acceptable alternatives to LIBOR for both new and existing securities.

While we’re interested to see how this change may effect global yields in various related products or markets as the transition progresses, our current view is that this is mainly a non-event for our direct alternative institutional investments. Several of our underlying managers are affected, but in each case thus far, our discussions with them on the topic have left us highly confident in their ability to manage to it successfully. Through both these direct and indirect capabilities, any subsequent inefficiencies may actually be a positive, as it breeds potential opportunity to take advantage.

While it will take time, the transition has already started and, from BlueBay’s point of view, it has so far been fairly rather frictionless. We are already primarily using ‘overnight index swaps’ instead of the traditional interest rates swaps which had been based on Libor. OIS rates and SOFR rates are based on the same concept of a secured lending rate and are trading close to repo rates. In the cash bond market, we are embracing the changes and do not foresee any major disruptions for our fixed-income portfolios going forward. On floating rates notes, while they have historically been issued with a spread to Libor, they are now more commonly issued with a spread to SOFR.

Both senior secured loans and the underlying financing for CLOs are both LIBOR based. The goal for the senior secured loan and CLO market is for both asset classes to shift away from Libor in tandem given CLOs represent over 50% of the buyer base in the senior secured loan market. The legal documentation for both asset classes now incorporate this eventual shift. There is still 2 ½ years until Libor is replaced so the markets have significant amount of time to properly make the shift.

Investors in bank sub debt are not expected to be impacted materially by this change because for the first five years after issue the notes are fixed rate. After a five year lock-out period the notes become callable and also floating rate. However, the notes also begin to lose their regulatory capital treatment in a step-down fashion each year until maturity. Banks will therefore be heavily incentivized to call the debt regardless of the prevailing rate environment and reissue new sub debt to maintain their regulatory capital requirements.