Bond Markets

Transition Issues

Legacy transactions

Floating rate bonds that reference an IBOR (e.g. LIBOR) are currently traded on the basis of known interest payments at the next coupon payment date. This is because IBORs are forward-looking term rates and an investor that holds such a bond has certainty, from one coupon payment date to the next, of the payment amount that it will receive on the next following coupon payment date.

RFRs, by contrast, are backward-looking overnight rates. For this and other reasons explained elsewhere, it is not possible, in relation to legacy FRNs, simply to substitute an IBOR for an RFR without adjustments (e.g. to the spread) to reflect the different metrics associated with the RFR. Moreover, systems will have to be adapted to take account of the different payment and accrual mechanisms (forward-looking/linear accrual under an IBOR versus daily compounding/non-linear accrual under an RFR), which in turn will have implications for booking and P&L.

The problem is accentuated where the coupon on an FRN is traded: that is, where the coupon is ‘stripped’ and the resulting ‘strips’ are traded. Whereas the stripped bond will be readily tradeable, the value of the strips at any point in time will depend on the interest that is payable at the next coupon payment date (which in an RFR context will be an unknown, at least until a few days before the relevant payment date).

As with all markets, a key issue associated with IBOR discontinuance is basis risk i.e. the risk that the value of a hedge will not move in line with that of an underlying exposure being hedged (or vice versa). This imperfect correlation of the hedge to the exposure creates the potential for excess (and, in the case of IBOR discontinuance, unexpected) gains or losses. In the context of an FRN, basis risk will arise where the rate associated with the bond is substituted with one RFR and the rate used in a related hedge is substituted with another. Basis risk may even arise in circumstances where the RFRs related to the bond and the related hedge are the same, due to differences in the payment mechanisms between the two instruments e.g. payment dates and observation periods. Synthetic FRNs (i.e. fixed rate bonds swapped into floating) are similarly vulnerable to basis risk.

Care will thus need to be taken to ensure that, in substituting the relevant IBOR with an RFR (or in agreeing fall-back mechanisms designed to effect such a substitution at a future date), the economics of the bond are preserved and any related hedge moves in tandem.

Other risks associated with IBOR discontinuance are highlighted below.

New transactions

In relation to new transactions, it is expected that the market will eventually settle on a preferred RFR (which will vary according to the currency and tenor of the relevant bond) and that markets will develop for the associated hedging instruments – although see further below. The same systems implications considered above will apply

Industry Position

Given how interconnected the bond and derivatives markets are, the volume of derivative contracts referencing IBORs and the strides that ISDA has taken in developing strategies to address the possible demise of LIBOR, it is expected that bond markets (led by ICMA) will follow the derivatives market’s lead in adopting appropriate fall-back mechanisms – although that has yet to happen.

By contrast to the derivatives market, there is no standard master agreement in the international bond markets. Nonetheless, there is a great deal of commonality in the drafting of the relevant provisions in bond terms and conditions, with outcomes being broadly consistent. That said, changes to the terms of legacy issuances cannot be effected by way of a Protocol mechanism as it can in the derivatives markets.

In recognition of some of the difficulties, the BofE Working Group on Sterling Risk-Free Reference Rates has published a paper (see Useful Links below) that considers the risks of issuing sterling bonds that reference LIBOR in the light of its impending discontinuance. In short, those risks are:

  • That floating rate bonds may become fixed
  • That bond terms and conditions may need amending (with appropriate bondholder consents – in the US, problematically, all bondholders may be required to consent)
  • That hedging arrangements and hedge accounting treatment may be impacted
  • Litigation risk (investor suit)
  • That bank capital instruments referencing LIBOR may not operate as intended
  • That the bond continues on a ‘zombie’ LIBOR basis (i.e. a situation where so few banks contribute to fixings, it is effectively a dead and unrepresentative rate)
  • Adverse regulatory compliance implications, and
  • Adverse rating implications.

In light of the foregoing, it is perhaps surprising that some investors and issuers are taking a relaxed stance.  A recent quote from the market went: “Small firms have shown little interest in transitioning from LIBOR, with some saying LIBOR-backed floating-rate notes continue to be issued daily. Both investors and issuers seem very comfortable that either these bonds will get novated to another index or that LIBOR should continue to exist until those notes mature”.

By contrast, some issuers are now including fall-back language in the terms and conditions of bond issuance programmes, albeit adopting a variety of approaches. Risk factors in bond prospectuses are also starting to address the question of IBOR discontinuance.

In a significant development for legacy transactions, early June 2019 saw Associated British Ports ask holders of its GBP 65 million FRN due 2022 paying 2.5% over 3 month LIBOR to vote on an amendment to the interest rate. The proposal sought to change the rate to 2.5% over compounded daily SONIA (backward-looking of course) plus a margin to equalise between bank risk versus risk-free. The notes had between 3 and 4 years to run, so this margin interpolated between the 3 and 4 year “3 million GBP LIBOR vs SONIA basis for Sterling basis swap transactions” which appeared on Bloomberg page ICAB9. It was the first time in the market that a legacy FRN issue amendment had been attempted. All the documentation – the “Consent Solicitation Memorandum”, the “Draft Supplemental Trust Deed” and the “Notice of Meeting” – is available on the ABP website. Following noteholder approval the same month, it is reasonable to expect that many other issuers will follow suit, even allowing for circumspection that some investors may feel in any rebasing that shifts value.

In this context, the January 2020 statement of the Sterling RFR WG, concerning progress on the transition of LIBOR-referencing legacy bonds to SONIA by way of consent solicitation, is a useful resource and aide-memoire.

As for new transactions, LIBOR-linked sterling FRN issuance beyond 2021 has, by all accounts, all but ceased.

Frequently Asked Questions

Q. Can’t I just substitute an RFR for IBOR in the note documentation?

A. No. The metrics are different and without an adjustment (e.g. to the spread) to compensate for this, the note economics will be fundamentally altered.

Q. Is a Protocol or similar solution to the problem contemplated?

A. No. It is likely that repapering will have to occur on a transaction-by-transaction basis. Industry help may be at hand, however. In the US for example, the ARRC has issued a set of recommended terms and conditions for new FRNs that reference LIBOR. In Europe, ICMA is developing a code that will enable bond market participants to transition LIBOR-based bond deals to SONIA.

Q. Can’t I just use the AFME language?

A. The AFME language is intended for RMBS transactions. It can be adapted, of course, to FRNs but consideration will still have to be given to how any related hedge deals will transition, so as to ensure that the bond and hedge move in tandem.

Q. Are there any other solutions?

A. Yes. One idea that has been mooted is that issuers, who wish to address IBOR discontinuance on the one hand and to keep their investor base on tap on the other, should simply buy back the relevant bonds and re-issue them so as to reference an RFR rather than an IBOR, adjusting the re-issue price and/or spread accordingly.

Q. What if i do nothing?

A. Failure to address IBOR discontinuance carries with it various risks over and above pure economic turbulence (including basis risk and the risk of conversion of the note coupon to a permanent fixed rate). In addition to contractual continuity issues, there are risks of regulatory censure, adverse reputational consequences and that investors may be able to sue issuers or arrangers for misselling or to make disclosure-based claims. There are rumours that hedge funds may be considering acquiring positions solely for the purposes of suing issuers and other deal participants.

Check list of things to consider

  • What are the relevant RFRs for my currencies/tenors?
  • When do I want the change to take effect?
  • Is there to be a spread adjustment?
  • Do my terms and conditions need amending? Ditto risk factors in prospectuses? 
  • Do I need noteholder and/or rating agency consent? Who pays?
  • Are there regulatory capital and/or compliance implications?
  • Are there implications for payment mechanics, financial covenant testing, mark to market etc.?
  • Are there accounting and tax implications as well as implications for P&L generally?
  • Is there a related hedge? How is IBOR discontinuance being dealt with in the hedge and do I need to follow suit in the bond? Alternatively, if my bond flips to a fixed rate, has my hedge become redundant and do I need to terminate it? At what cost/gain?
  • Can I do a SONIA-based deal instead?

Fieldfisher Contacts

Bond Markets

Gary Walker

Phone: +44 (0)207 861 4619

Gonzalo Fernandez

Phone: +44 (0)20 7861 4906

Richard Todd

Phone: +44 (0)20 7861 4781

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