You need an interesting title when writing about a topic that tends to have people nodding off after the first sentence. So what is the deal with this LIBOR thingy then?
LIBOR – the London Inter-bank Offered Rate – is going down the drain, thanks to the traders who decided to make up the rate for the next day’s cost of overnight money at dinner one night. We always knew that the Libor fix was a bit dodgy in some of the less transparent overseas markets. That’s why some interest rate swaps trade versus the very liquid USD floating rate and not the domestic floating interest rate (think Russia and Turkey). But for a more established market such as the UK, the scandal was a bit of a shock, though probably a good thing in the long term given that the changes being introduced will make the rate materially more robust and trustworthy.
I have written about the story before, but it’s worth updating a few points.
Firstly, the US Federal Reserve has begun publishing its new overnight reference rate in the US – SOFR, or the Secured Overnight Financing Rate. This is a little different to the UK SONIA rate (Sterling Overnight Index Average rate) as the US SOFR is based on secured transactions as opposed to SONIA’s unsecured rate. (Typically a secured funding rate is lower as the lender receives security against government bonds).
Going forward, the Chicago Mercantile Exchange (CME) is going to launch futures contracts on the new rate, adding to the existing EuroDollar futures market. Later this year, clearing will start for SOFR swaps. So while we are a long way off replacing the LIBOR swap market in the US, it’s the direction of travel.
Over here in the UK, the SONIA fixing is getting a fancy new haircut and shiny new trainers: it’s going to be “reformed”, with more breadth of transactions and a slightly different averaging calculation. So we get a nice trustworthy benchmark, administered by the Bank of England, which we can all transition to from the market’s LIBOR legacy book.
Think about that last line a minute: “that we can all transition to from the market’s LIBOR legacy book”. Who has a legacy book?
Investors using a liability-driven investment strategy (LDI) have a legacy book. Many practitioners in LDI swap their long-dated cash flows (think 30, 40, 50 years) using LIBOR. The market will need to replace LIBOR when it is finally retired (date to be determined). So we have seen a pickup in new hedging being done in SONIA as opposed to LIBOR. This can be seen in the spread between the LIBOR and SONIA rates, which has moved noticeably as shown in Chart 1 below.
Chart 1: 30-year LIBOR – SONIA swap spread
How does this affect a pension mandate then?
Most schemes using swaps are ‘in the money’, as those that have ‘received fixed’ from an older, higher interest rate environment now have a paper profit.
In all of these in-the-money swaps, there is a risk of the current discount curve (SONIA) moving differently to the forward curve (Libor) – so the market needs to pay close attention to SONIA moves relative to LIBOR. Guess what? That’s happening now!
How far this relationship goes and the implications for numerous pension schemes is unclear, but what is certain is that it’s a regime change, so expect a bit of a ride.