Transition from LIBOR won't be easy for money managers

The U.K. Financial Conduct Authority is urging CEOs of money management firms to stop buying LIBOR-linked cash products — including bonds and loans — by the end of the third quarter, but managers said that won't be an easy thing to do.

Managers say they are facing challenges when it comes to switching their strategies' exposure to LIBOR replacement rates-linked securities, such as the secured overnight financing rate in the U.S., known as SOFR, and the sterling overnight index average in the U.K., known as SONIA.

And even a coronavirus disruption is not going to give them breathing room when it comes to a transition away from LIBOR.

The U.K. financial services watchdog said on March 25 the effects of the virus on markets are not going to delay the expected timelines for when managers and banks operating in the U.K. should switch to buying and issuing products based on the new rates.

Debt managers in particular are currently finding it difficult to source SONIA-linked loans as banks are slow to issue them. Managers can't buy many products based on alternative rates today, said Adam Schneider, partner at Oliver Wyman Group in New York. Mr. Schneider added that a third-quarter 2020 move to alternative rates will be a problem because futures trading based on the new rates such as SONIA or SOFR still has low volume.

But LIBOR — which serves as a benchmark in many institutional portfolios for determining performance and features in structured products, real estate funds, corporate bonds and syndicated loans or leveraged loan funds — isn't being replaced by SONIA or SOFR effectively, other sources said.

When managers are left to buy only SONIA- and SOFR-linked securities at the end of the third quarter 2020, they expect to see an impact of the new overnight rates on the valuation, pricing and product costs. That's because LIBOR is calculated as a six-month average interest rate and is not as volatile or spot-like as the overnight rates SONIA or SOFR. Investors and managers face a potential mismatch between the valuation, pricing and costs on LIBOR when moving to SOFR/SONIA products because of the differences.

Switches could also be charged to money managers' or their clients' bill, according to Richard Keers, London-base group chief financial officer at Schroders PLC, who warned on Feb. 12 that a conversion to replacement rates-linked products from LIBOR-linked products will result in a payment to account for the change in the underlying rate. "While new industry conventions are being developed to minimize the value transfer (that would have to be paid at the time of the transition), they will not remove it entirely," he said on Schroders' website. "This payment could be due to or required to be paid by a client's portfolio."

Managers have been waiting for a LIBOR transition since 2017, when the FCA announced plans to end use of the rate as a result of a price-fixing scandal that involved bankers artificially manipulating LIBOR to profit from trades.

Now firms have until the end of 2021 to make the switch to either SOFR in the U.S. or SONIA in the U.K. But in its letter to U.K.-based managers on Feb. 27, the FCA called on top executives to make the switch sooner.

"There are risks to the valuation, pricing or cost of LIBOR product in the event the rate is no longer published," the FCA said. The FCA also said that managers must prepare as replacing the old rate may raise tax, accounting and legal risks.

But meeting the FCA's criteria to buy only SONIA-linked loans from the third quarter will be a challenge as managers say some banks will struggle to issue solely SONIA-linked loans and some managers' funds might need to adjust their investment policies in order to buy securities linked to rates other than LIBOR.

A shortage of SONIA-linked loans issued by banks is making it difficult for managers to source new deals in real estate or other sectors, said Andrew MacDonald, head of real estate finance at Schroders in London.

"It's an issue," he said, adding that not all counterparties, such as banks, have made the switch to SONIA themselves, with some lacking systems to support SONIA-based operations. McKinsey & Co. Inc. estimated in November 2019 that between 50% and 75% of banks' risks models involve LIBOR and will need to be redeveloped.

Oliver Wyman's Mr. Schneider added that buy-side firms may not have the flexibility to avoid a LIBOR phaseout in the third quarter of 2020.

Investment managers don't have much visibility or analytical tools to figure what is going to happen after LIBOR has ceased to exist but they have fiduciary obligations to make decisions, Mr. Schneider said.

"If you have some flexibility, it would be very smart to stay out of this until the market develops. But if you are stuck with guidelines to buy bank loans or (offer a) LIBOR-plus fund, then what do you buy?" he said.

Because LIBOR is ubiquitous in the securities and financial markets — the rate features in securities, transactions and strategies that touch on $240 trillion of investment products according to Oliver Wyman's data — managers will also have to examine existing LIBOR-linked strategies to identify the conditions set in every contract written between the loan issuer and the manager. The FCA said managers should consider whether they face risks of "contractual frustration if products continue to reference LIBOR beyond 2021."

For strategies that utilize LIBOR-linked products that mature after 2021, managers will have to rely on "fallback" language in their contracts to avoid mismatches, sources said. Such wording in contracts and other fund documents clarifies what rate should be used when LIBOR is not available.

Mr. MacDonald is currently comparing the language around the loans in his real estate strategies to see if there are potential mismatches when he has to move from LIBOR. "If the loan rate matches the interest rate swap, there is less of an issue," he said.

"We are preparing for (the end of LIBOR) by going through portfolios which have exposure to floating-rate instruments that have LIBOR as benchmark," said Tracy Chen, portfolio manager and head of structured credit team at Brandywine Global Investment Management LLC in Philadelphia. Ms. Chen added that the firm is checking the fallback language needed to see if it would be appropriate for when the firm's move away from LIBOR.

However, she said that contracts related to instruments that state "the last known LIBOR" as the fallback rate, will change rate benchmarks or cease to be variable-rate instruments after LIBOR is phased out. "We are identifying our exposures and potential risks," she said.

But George Bollenbacher, who was head of fixed income and currencies research at TABB Group in New York before the firm closed on March 13, said not all managers are aware of the challenges that a transition away from LIBOR entails. "Some managers haven't yet woken up," he said.

Mr. Bollenbacher said, by way of example, that if the fallback language doesn't exist in contracts and if an overnight rate such as SOFR is agreed in place of LIBOR, then managers might have agreed to a different rate that in a positive yield curve would penalize holders of SOFR-based assets.