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LDI portfolios could face risks in move away from LIBOR

Sathish Ramdayal, Mercer
Sathish Ramdayal thinks investors should prepare by simplifying their derivative positions.

The U.K. financial regulator's decision to scrap LIBOR in 2021 could impact the derivatives market, with a knock-on effect for pension funds that use the instruments in liability-driven investing and other portfolios.

The Financial Conduct Authority said July 27 that it would terminate the London interbank offered rate because the interbank lending market was becoming increasingly defined by scarce transactions, making it more likely to be manipulated as was the case a decade ago.

But money managers are concerned the move to a new short-term benchmark might have a negative impact on as much as $30 trillion of financial transactions, including the interest-rate swaps market and carry trades that use LIBOR as the reference. Consultants and managers also said there is not yet enough clarity from the regulator on an adequate replacement for the benchmark.

Pension funds use LIBOR-based derivatives contracts in their LDI portfolios and elsewhere.

Approximately 350 billion ($456 billion) of the total 908 billion of liabilities hedging is done via swaps referencing LIBOR, according to KPMG data.

"As no clear alternative has been defined, the contracts currently running (and due to finish after 2021) would need to be amended and market participants may find themselves unable to price instruments. There is a potential for a significant market disruption," warned Menno van Eijk, head of cash solutions and investments at NN Investment ​ Partners in the Hague, Netherlands.

Sathish Ramdayal, head of structured investments in the U.K. at Mercer, based in Edinburgh, said many pension funds get interest rate exposure on the short end of the curve through interest rate swaps, which use LIBOR to determine the market price, contrary to the long end where gilts serve them better. "Switching away from LIBOR could impact the value of these investments for pension funds, unless suitable adjustments are made as part of the transition," he said.

There is also a question over the future pricing of total return swaps and floating-rate securities, because LIBOR is used to determine how much coupon is being paid on short-term debt transactions.

"For example, total return swaps, which many pension funds use to gain significant gilt and equity exposure, could have their proceeds and values affected. So, it's not just interest rate swaps that will be affected, (albeit) total return swaps are shorter-term contracts than interest rate swaps," said Mr. Ramdayal.

Other asset classes, including private debt, could face similar challenges associated with a transition period.

"We see the key challenge being around the practicalities of having to deal with the transition arrangement for all of the existing loans that have maturities out past 2021," said Max Mitchell, senior managing director and head of direct lending, Europe, at Intermediate Capital Group PLC, London, a money manager with €23 billion ($27 billion) under management.

Pacific Investment Management Co., which runs $1.22 trillion, warned in an Aug. 17 viewpoint that the LIBOR alternative should have sufficient liquidity before the transition occurs.

Not all sunny with SONIA

While sources said there is little clarity around a LIBOR replacement, the FCA said the sterling overnight index average, SONIA, should be used. SONIA's methodology will be overhauled by the Bank of England before April 2018.

But while a number of managers see SONIA as a workable alternative, others highlight drawbacks such as its potential for higher volatility.

"We have done some preliminary work to understand whether or not SONIA could satisfy the requirements of the loan market, for both borrowers and lenders and early indications suggest that SONIA could work," Mr. Mitchell said. "However, because it demonstrates periods of higher volatility than LIBOR … if you are a borrower, this volatility is unhelpful as it will add cost and execution risk."

Some see benefits

Some money managers said the elimination of LIBOR could actually be beneficial for pension funds when they move to an alternative rate. As the market moves away from the unsecured LIBOR, there could be opportunities for pension funds to save money through switching to SONIA-based swaps early or choosing an alternative secured reference rate. According to index provider STOXX, a secured reference rate could mean pension funds save the equivalent of five basis points per transaction. European pension funds using EONIA — SONIA's European counterpart — as the reference rate for swaps could save about five basis points by benchmarking to the STOXX GC Pooling, an index provided by Stoxx and endorsed by the European Central Bank.

In the U.S. market, which also uses LIBOR, the lack of a clear alternative might prompt investors to shift some LIBOR swap trading volumes into overnight index swaps. According to Bank of America Merrill Lynch's forecast, in the near-term the overnight index swap markets referencing the fed funds rate is likely to increase in depth and liquidity as an alternative to LIBOR swaps. Separately, the Fed's broad Treasury financing rate and overnight bank financing rate could increasingly be used.

Until further clarifications are made on any replacement, Mercer is not advising pension funds to make material changes to their LIBOR-based derivatives. Still, Mr. Ramdayal said it is important to ensure investors begin to prepare for the changes and simplify their derivative positions where appropriate.