Largely due to its history of scandal and manipulation, LIBOR is being phased out. While this isn’t new information, we’ve been tracking updates here at United. The rate is being replaced with SOFR, or the Secured Overnight Financing Rate. Since many financial obligations with floating rate structures are tied to LIBOR, we feel this transition and the accompanying details is very important. Some details remain to be hammered out, but we note some of these relevant points:
LIBOR is expected to be completely phased out by Q4 2021. SOFR is the replacement rate.
The transition will primarily impact longer dated bonds and obligations. Many will mature before Q4 2021 and thus won’t be impacted.
SOFR is naturally a lower rate than LIBOR. This is partly due to the fact that SOFR is a secured rate, while LIBOR is supposed to reflect the credit risk of financial institutions.
SOFR can only be observed back to 2014, but it tracks fairly close to the fed funds rate.
Given that LIBOR is a higher rate than SOFR, a direct replacement would abruptly change the rate on many financial instruments. Since this would be very problematic, there is likely to be a ‘spread adjustment’ of about 10 basis points. An obligation that previously paid 3 Month LIBOR + 100 basis points would in theory be converted to SOFR + 110 basis points.
While the transition will impact many types of financial obligations, we are most interested in its impact on LIBOR linked bonds, preferred stocks and bank loans. We find that in situations like this, refining our understanding ahead of time helps us to identify value for clients when dislocations occur.
Matt DeLorenzo, Fixed Income Strategist