IBOR transition: Bonds


The transition from IBORs to alternative near risk-free reference rates (RFRs) has continued to progress in 2020. Whilst momentum may have slowed somewhat due to market participants’ resources being diverted due to the Covid-19 pandemic, official guidance from regulators has confirmed that the goal post of transition to RFRs by the end of 2021 has not shifted.

In the bond markets, significant progress has been made in the transition to RFRs, particularly for new issues. There have been significant volumes of new SOFR and SONIA-linked FRNs issued; and new public issuance of sterling LIBOR-linked FRNs and securitisations with a maturity beyond the end of 2021 has all but ceased.

One area that is still being bedded down is the market convention for interest calculation for SONIA FRNs. The convention has typically involved referencing SONIA compounded in arrears over an interest period, with a margin added, and a “lag” in respect of each interest period. However, in February 2020, EBRD issued a SONIA FRN which used a five day observation period “shift” approach (similar to the “lag” approach but the compounding formula weighted the SONIA rate to account for calendar days when the SONIA rate is not published according to the observation period (rather than the interest period)). The "shift" approach is compatible with the daily SONIA compounded index published by the BoE from August this year and it may mean that the market moves towards using the "shift" approach in time.

Some market participants are embedding the optionality of issuing SONIA FRNs via both the “shift” and “lag” approach in their base documentation to give them flexibility. However, the “lag” and “shift” approach could continue to exist side by side as there is no substantive difference in coupon amount for each approach. If both of these approaches are to co-exist, it will be important for investors to be able easily to identify which approach is used for each individual bond.

While considerable progress has already been made in relation to transition to RFRs in new issues of FRNs, there are many existing bonds that still reference LIBOR that are due to mature beyond 2021 that do not contain robust fallbacks (legacy bonds). 

For legacy bonds, a transition away from LIBOR can be achieved by way of consent solicitation: a market-based process which enables an issuer to amend bond conditions by way of bondholder consent. However, progress has been slow in this area due to the fact that consent solicitations can be time consuming, costly and, in the case of bonds with high consent thresholds, unsuccessful. This was recognised by the Sterling RFR Working Group (RFRWG) who issued a paper on “tough legacy” issues in the transition from LIBOR in May 2020. The taskforce proposed that the UK Government should consider legislation to address tough legacy exposures. In response, the UK Government announced that it intends to amend and strengthen the Benchmarks Regulation, rather than directly impose legal changes on LIBOR-referencing contracts that are governed by English law. In its written statement, the Government stated that “the legislation will ensure that, by the end of 2021, the FCA has the appropriate regulatory powers to manage and direct any wind-down period prior to eventual LIBOR cessation in a way that protects consumers and/or ensures market integrity”.

Whilst the legislative solution has been welcomed by the market, the authorities still consider that the smoothest transition from LIBOR will be one in which contracts that reference LIBOR are replaced or amended before the fallback provisions are triggered. This was recognised by the RFRWG in its paper on active transition of GBP LIBOR-Referencing Bonds published in September 2020.

In the US, the position is slightly different as the consent threshold in New York law governed bonds is typically 100 per cent and therefore consent solicitation exercises may not be as effective. Therefore, unlike in the UK, the US authorities are not actively encouraging market participants to transition as many bond contracts as possible by way of consent solicitation. A likely outcome of this is that upon the permanent cessation of LIBOR, there would be a significant volume of New York law-governed bonds that fall-back to a fixed rate. Therefore, in March 2020, the Alternative Reference Rates Committee (ARRC) in the US released details of a "Proposed Legislative Solution to Minimise Legal Uncertainty and Adverse Economic Impact Associated with LIBOR Transition" for New York law-governed transactions, which would require the use of the ARRC recommended benchmark replacement instead of falling back to a fixed rate on the permanent cessation of LIBOR, and in contracts where there are no fallbacks. 

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