Frequently Asked Questions:
1. How else may investment managers use LIBOR or other interbank rates?
Apart from being used to calculate payments due under derivatives transactions, bonds and loans, these rates have a number of other uses. For example, some funds and mandates use LIBOR or another interbank rate as a benchmark in their investment objectives, performance fee calculations, asset allocation models and to provide a comparison to the rate of return a fund manager achieves. LIBOR and other interbank rates are also relied on by financial firms from an operational perspective, including in the valuation and pricing of investments, and to assess financial risks (e.g.in stress testing scenarios).
2. How do replacement rates/Risk Free Rates (RFRs) differ from LIBOR and other interbank rates (“LIBOR/interbank rates”)?
There are important differences:
- LIBOR/interbank rates look forward, i.e. they are set at the start of an interest period or payment period, using a rate that will then apply throughout that period. The length of the period is agreed by the parties to the transaction, and can range from one day or overnight to twelve months. Different interest rates apply to different time periods: usually the longer the period, the higher the interest rate. RFRs look backwards: they are determined at the end of each interest or payment period, and calculated using the cost of borrowing money overnight for each day of that period.
- LIBOR/interbank rates are the rates banks charge each other to borrow money, and include a risk “premium” to cover the risk of any bank borrower failing to repay amounts owed to the lender. RFRs do not take this risk into account.
- LIBOR/interbank rates assume that the borrower bank is not providing any security (collateral) for the loan. Some RFRs make the same assumption (SONIA, ESTR and TONA). However, other RFRs assume that security is provided (SOFR and SARON). Security provides the lender with protection: if a borrower defaults on the loan, the lender can take the security as payment for any sums owed. Where the borrower provides security, the interest or payment rate it has to pay will be lower.
- RFRs are lower than the LIBOR/interbank rates, since RFRs do not take into account the higher rates charged for lending over longer interest periods, or the risks of lending to a bank; and some RFRs assume that the borrower is providing security. Therefore if an existing transaction using a LIBOR/interbank rate is to be changed to use an RFR, market participants expect to add an additional amount (a “spread”) to the RFR. Bloomberg publishes a number of RFRs, and spreads applicable to them.
- Central banks or their delegates are more closely involved in the administration of RFRs than is the case with LIBOR/interbank rates.
3. How will the change from LIBOR/interbank rates to replacement rates/RFR’s affect me?
- Where we have invested in any bond, loan or derivative trade that refers to a LIBOR/interbank rate but matures after that rate is expected to cease, we will need to amend its terms to refer to a replacement RFR plus a spread. We will do so before each LIBOR/interbank rate ceases to be available (e.g. 31 December 2021 in the case of LIBOR). Our exact timing will depend on when and to what extent the markets for RFRs develop. We continue to focus on achieving the best outcome for our clients. Liquidity and underlying risk characteristics are key factors in this. Transitioning to any replacement rate is contingent on the development of that specific market and the provision of data from appropriate data providers. We may trade on RFRs if doing so allows us to achieve best execution, but this may not preclude us trading LIBOR/interbank rates in certain instances whilst they are available, depending on pricing, liquidity and other factors.
- We expect that changing the terms of a transaction or investment so that they refer to an RFR rather than LIBOR will result in a payment being made from one party to the other, since the value of the transaction or investment to each party will change. This means that each investor’s portfolio will pay or receive money in respect of each such change.
- Where a fund or mandate we manage uses a LIBOR/interbank rate as a benchmark, e.g. to determine the intended return for investors, or for performance comparison purposes, this benchmark will need to be replaced by another appropriate benchmark, which could be an adjusted RFR or another market rate.
- Where we use LIBOR or an interbank rate for valuation purposes, to calculate risk performance or other statistics, or in our accounting or tax processes, we will need to use another rate.
- First Sentier investors is actively considering how and when to make these changes, and will inform you as and when we think necessary of any developments that may affect you materially.
4. How easy will it be to change the terms of a bond, loan or derivative trade that refers to a LIBOR/interbank rate, to refer to an RFR instead?
- Different sectors of the market are at different stages of readiness in respect of providing standard documentation to assist with the transition to RFRs:
- The derivatives sector is the most advanced. The derivatives trading association, International Swaps and Derivatives Association (ISDA), has issued documentation that allows market participants to include fall-back provisions, which determine the RFR to use in the even that LIBOR or another interbank rate ceases to be available, effective from 25 January 2021 in the case of new trades. Parties can elect to apply these terms to existing transactions by signing an ISDA Protocol to that effect.
- The bond sector and the loan sector are working on template documentation that provides for fall-backs to RFRs, but there is less consensus globally on terms at this stage.
The adoption of standard terms by a sector of the market should assist us in negotiating changes to transactions in that sector, which we will seek to agree before the relevant LIBOR/interbank rate ceases to be available, if possible. Where such standard terms are not available, the course of these negotiations will be less predictable.
- Negotiations may prove challenging in some instances: for example, to amend the interest rate on a bond usually requires the consent of between 75% and 100% of the holders of the bond.
- Legislative initiatives have been proposed in the UK, the EU and the US which may assist the transition process in certain instances, however the precise scope and effect of these initiatives will only be known when any such legislation is passed in final form. We are monitoring these developments closely.
- We will ensure that we implement this transition in accordance with applicable regulatory guidance, which for GBP LIBOR we see as requiring cessation of use of that rate by the end of 2021, and a material decrease in GBP LIBOR positions by 31 March 2021. US regulators support the end of new issuance of USD LIBOR products by mid-2021, and cessation of use by the end of 2021. The Financial Stability Board has said that by 30 June 2021 firms should have established formalized plans to amend LIBOR contracts, and have implemented changes required to enable transition to robust alternative rates. We are monitoring these developments closely.
5. What are the main areas of work that First Sentier Investors is engaged in to effect transition?
- First Sentier Investors has largely completed its inventory of exposures to and uses of LIBOR and other interbank rates as set out in answer 3 above, and assessed the impact of those exposures and uses.
- First Sentier Investor’s portfolio managers are assessing how and when to transition positions and uses away from LIBOR and other interbank rates, having regard to the considerations set out in answers 3 and 4 above.
- Our Operations team and the third party provider of our order management system are engaged in effecting the changes required to be able to transact under RFR’s.
- Our project steering group is monitoring regulatory and market developments with reference to sources including:
- Regulators such as the UK FCA, the US Alternative Reference Rates Committee (ARRC) and the European Securities and Markets Authority (ESMA);
- Industry associations such as the Investment Association, ISDA and the International Capital Market Association (ICMA); and
- Providers of legal services: law firms and Practical Law’s information service.
6. Will the Coronavirus delay the timetable for the transition away from LIBOR?
No delay is not expected for this reason. The UK FCA confirmed this in March 2020, stating that firms cannot rely on LIBOR being published after the end of 2021.
This material is not intended to be relied upon as a forecast, research or as legal, regulatory or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of November 2020 and may change as subsequent conditions vary.
The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by First Sentier Investors to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by First Sentier Investors, its officers, employees or agents. This material may contain “forward-looking” statements which may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed.
Issued by First Sentier Investors (UK) Funds Limited which is authorised and regulated by the Financial Conduct Authority (registration number 143359). Registered office Finsbury Circus House, 15 Finsbury Circus, London, EC2M 7EB number 2294743. A member of MUFG, a global financial group.