Personal point of view: what does it mean for you to leave LIBOR?
For more than 40 years, the London Interbank Offered Rate (LIBOR) has been an important benchmark for determining the cost of floating rate bonds around the world.
LIBOR also plays a large role in pricing corporate debt securities. After the 2008 financial crisis, the integrity of LIBOR was called into question due to concerns about manipulation. A decline in the unsecured interbank credit market has also significantly reduced the volume of transactions on which the panel banks’ estimates are based. Since the LIBOR rates are a less reliable benchmark, the regulatory guidelines require banks to stop issuing new LIBOR loans by the end of 2021 and to switch existing LIBOR loans to other indices by June 30, 2023.
To expedite the transition, the Alternative Reference Rates Committee (ARRC), a group of private market participants, was convened by the Federal Reserve Board and New York’s Federal Reserve Bank to look for alternatives to LIBOR. ARRC is leading the transition away from LIBOR and is responsible for publishing recommended best practices to outline key transition activities and milestones.
In addition, the International Swaps & Derivatives Association (ISDA) is leading the transition of the US dollar LIBOR derivatives markets (e.g., interest rate swaps) away from LIBOR. ISDA and ARRC are working closely to confirm the alignment of their goals.
In 2017, ARRC recommended a new overnight risk-free benchmark, the Secured Overnight Financing Rate (SOFR), as a replacement benchmark for US bond and credit market transactions. The New York Federal Reserve Bank now publishes SOFR as well as SOFR averages and a SOFR index on a daily basis. Also recommended by ARRC, the Daily Simple SOFR convention calculates and aggregates interest on a daily basis and is used for many types of corporate loans.
However, the transition to SOFR is not without its challenges. Since the daily SOFR reflects overnight interest rates, borrowers may not like them because they are less able to predict payments and their loans would not reflect expectations of interest rate changes – one of the main attractions of LIBOR. To address this issue, on July 29, 2021, ARRC officially recommended the Chicago Mercantile Exchange Group’s forward-looking SOFR rates of 1 month, 3 months, and 6 months for commercial loans, and the number of SOFR-linked products is growing.
Another problem is that, unlike LIBOR, the new interest rates do not capture the credit risk banks take on lending. As a result, some market participants and industry groups are in favor of an established benchmark such as Prime or newly created benchmarks such as the American Interbank Offered Rate (AMERIBOR), Bloomberg Short-Term Bank Yield Index (BSBY) and some of them are used. , or ICE Bank Yield Index (BYI).
While alternatives to SOFR – including credit-sensitive interest rates – continue to be discussed, most market participants follow the ARRC recommendation to use SOFR as a substitute reference rate. If you have an adjustable rate loan based on LIBOR, find out which index your lender will switch to. If you are considering new adjustable rate debt, ask your lender about options. Even if there may not be any firm answers now, keep an eye on the situation. Switching to a different index could potentially change your base rate in the future.
Doyle is the Commercial Sales Leader for KeyBank in Cleveland.