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Interest Rate Reform – Practical implementation

Debt Issuance from 2020: Themes for the year ahead

With just under two years remaining to the end of 2021, beyond which the continuation of LIBOR is not guaranteed, the transition away from LIBOR in the bond market is gaining traction. The adoption of riskfree rates in the floating rate note (“FRN”) market has shown promising momentum, with significant issuance over the last eighteen months in SONIA, as the risk-free rate in place of GBP LIBOR.

Adoption

In the SONIA FRN market, a standard set of market conventions has developed, despite initial concerns that the absence of a forward term structure would cause difficulty. Under these conventions, the overnight rate is compounded over an observation period, with a short “lag” (or “lookback”) period (typically five days) between the observation period and interest period allowing parties to calculate the interest rate ahead of the payment date. Whilst issuance in the new risk-free rates has been dominated by financial institutions and supranational issuers, there are signs that corporate issuers will follow.

In USD, SOFR has been less quick to gain momentum as the replacement for USD LIBOR. This arises from a combination of factors, including the lack of an agreed set of market conventions being adopted by a critical mass of issuers. The Alternative Reference Rates Committee (ARRC)1 in the US have made a suite of resources available to market participants including an Appendix of indicative term sheets comparing key provisions for SOFR FRNs.

In the Euro area, the EIB kickstarted the €STR FRN market with an issuance timed to coincide with the publication of the new rate on 2 October 2019.

Transition

Outcomes for legacy transactions are subject to increasing scrutiny. Transition of legacy products is likely to be a key focus of the year to come. A number of FRN issuers in the UK have now successfully undertaken consent solicitation processes, seeking bondholder approval for a transition from LIBOR to SONIA. It is acknowledged, however, that this will not be a solution for the market as a whole, and the Working Group on Sterling Risk-Free Rates has established a new Tough Legacy Task Force to identify and mitigate the extent of contracts which may prove impossible or impracticable
to transition relying on market-led solutions alone. In the US, the ARRC have published a proposal for New York State legislative relief (i.e. a statutory mechanism to change to a new rate for legacy LIBOR contracts) in the minutes of their November 2019 meeting. Given that the vast majority of FRNs referencing LIBOR are USD denominated and therefore many will be governed by New York law, next steps will be closely watched by the market.

Fallbacks

Output from the relevant currency specific working groups, the official sector and ISDA continue to inform the drafting of bond fallbacks, including in
relation to the benchmark events that trigger the operation of the fallbacks. As there is more clarity on applicable replacement rates as well as the appropriate methodology for calculating the relevant spread, it may be that fallbacks in multi-currency debt issuance programmes evolve further during 2020.

For more information visit our Global Interest Rate Reform page.

 

1. The Alternative Reference Rates Committee is a group of privatemarket participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar (USD) LIBOR to a more robust reference rate, its recommended alternative, the Secured Overnight Financing Rate (SOFR).

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