Key takeaways
  • The shift to Risk Free Rates (RFRs)1 for legacy bonds will have a significant impact on bond issuers and investors. With deadlines fast-approaching, it is critical market participants activate the relevant processes to amend legacy contracts to factor in the transition away from LIBOR to the RFRs.
  • As a market-wide logistical challenge, the transition is also an opportunity for the market to improve communication processes between issuers, investors, agents and broader participants.
  • Through regular client engagement and technology upgrades to its bond servicing platform its HSBC Issuer Services is supporting customers with their operations as they start to incorporate RFRs.

 

The transition away from IBORs (Interbank Offered Rates) - the interest rate benchmarks underpinning financial contracts including bonds, derivatives, securitisations, mortgages and loans – is widely considered to be one of the most significant structural overhauls to impact capital markets. HSBC Issuer Services, in collaboration with Allen & Overy, outlines how the shift from LIBOR (London Interbank Offered Rate) to RFRs will transform the bond market.

1. What are the key drivers behind the IBOR transition?

The LIBOR discontinuation plan was triggered by a number of factors. The market activity on which LIBOR has historically been based – namely interbank unsecured term borrowing – has significantly reduced in size as banks moved away from unsecured short-term financing following the 2008 crisis, in favour of alternative funding sources such as bonds and repos. This downward trend in volumes has been a key catalyst for the transition, challenging LIBOR’s ability to continue playing its central role. As the benchmark upon which LIBOR is based is now only a fraction of its original, the benchmark rate for some tenors may not always be representative.

Furthermore, a number of instances of misconduct involving the LIBOR rate setting process has damaged regulatory authorities’ confidence in LIBOR.

In many instances, it had become obvious that the panel banks’ submissions were based on expert judgements as opposed to factual transactions2 . RFRs are also preferred to IBORs for several other reasons. SONIA (Sterling Overnight Index Average), the GBP LIBOR replacement rate recommended by the RFR WG (Working Group on Sterling Risk-Free Reference Rates), which measures the rates paid by banks on overnight funds, corresponds to a more active and liquid underlying market, a point repeatedly made by the Bank of England.

 

What are the replacement benchmarks and which benchmarks are changing?

RFR working groups in a number of jurisdictions have identified replacement benchmarks and continue to develop strategies for transition. Select examples of benchmarks which are either being replaced or benchmarks where changes either have or are expected to be made to their methodology (notably the way in which they are determined) are set out in the table here.

 

2. How will the transition impact the wider bond market?

A number of global regulators including those in the UK, US, EU, Singapore, Hong Kong, Switzerland, Canada and Australia are moving away from their respective IBORs (Interbank Offered Rate) towards alternative risk free rates (RFRs).

“The changes have and will impact the bond market because IBOR is a forward looking rate whereas the RFRs being adopted are generally backward-looking in nature being based on overnight rates. This will have major consequences for issuers and investors alike,” said Brett Moody, Head of Structured and Conventional Debt Client Services at HSBC Issuer Services.

In the UK, the market is shifting away from LIBOR to SONIA with the former effectively ceasing to exist from 31 December 2021. All floating rates for new bond issues already reference a different benchmark, in most cases SONIA compounded in arrears. As of 31 March 2021, LIBOR has ceased for new GBP bond issuances. Most existing bonds issued with LIBOR terms will need to be transitioned to avoid potential contractual, economic and legal risks with the panel ceasing to exist. The implications of this transition should not be underestimated by bond issuers.

“The IBOR end-date deadlines are fast approaching, and it is going to be a huge logistical challenge to transition deals in such a short time-frame,” noted Morgan Krone, a finance partner at Allen & Overy.

Bond market participants – be it issuers or investors – will need to have adapted their systems and infrastructure to accommodate the changes in methods for the new ways of calculating interest on bonds.

Brett Moody

3. What are some of the key considerations bond market participants need to take into account vis a vis the transition?

At the point at which IBORs end, the benchmark rate on which bond interest is paid to investors will change, as the new rates will be based on RFRs. “As a result, bond market participants – be it issuers or investors – will need to have adapted their systems and infrastructure to accommodate the changes in methods for the new ways of calculating interest on bonds,” said Moody.

The issue is particularly acute for legacy bond transactions as many of these contracts will reference IBORs. As we approach the transition deadline, bond market participants will need to update and amend their contracts and, where relevant, before any fallback provisions are triggered. Far from being a straightforward exercise, as it requires majority (often 66 per cent + or 75 per cent + under English law) noteholder consent, this process will require multiple layers of anticipation, implementation and coordination.

For instance, market participants will need to identify early on the impacted transactions, across products, and follow closely guidance from regulators on how the related contracts should be updated. This also implies that they are equipped to deal with the influx of work required to manage potentially significant volumes.

The transition gives us a unique ability to add value to our clients, by providing guidance in relation to the process required to move from forward looking rates to backward looking ones. We are keen to ensure that implementation of the new methodologies goes as smoothly as possible.

Tom McKay

4. Why is this process of obtaining noteholder consent potentially quite onerous?

Unlike a derivatives trade where two counterparties are involved in a transaction which is subject to an ISDA (International Swaps and Derivatives Agreement) protocol, the process for amendment for bond markets is far more complex. “Bond transactions by nature involve the active participation of a large number of counterparties, therefore it can take upwards of 50 to 70 days to get all of the amendments through,” commented Moody.

Issuers and noteholders’ early engagement can help accelerate proceedings. “If a noteholder does not engage with other participants, then amendments cannot be considered at meetings, which is a market-wide risk,” said Tim Bates, senior associate at Allen & Overy.

It is likely that there will be an irreducible core of “tough legacy” contracts that are unable to effectively transition by the LIBOR cessation deadline of 31 December 2021. “For these transactions, where there is no meaningful fallback rate available and an inability to amend, we are hopeful that the new powers afforded to the Financial Conduct Authority (FCA) under the recently enacted Financial Service Act 2021 will be able to be utilised broadly enough to capture the bulk of the non-transitioned contracts,” added Tom McKay, Global Head of Defaults, Restructurings, and Fiduciary Risk at HSBC Issuer Services. The FCA’s consultation “how we propose to use our powers over use of critical benchmarks” concluded on the 17 June, and market participants eagerly await the results. However, Edwin Schooling Latter, the Director of Markets and Wholesale Policy at the FCA, has reiterated in a speech on 5 July 2021 that “while these new powers can help ensure there is a safety-net in place, they don’t remove the need for you to act. Any safety-net the FCA provides would only be for a time-limited period. Market participants are encouraged to amend their contracts where they can”.

Trustees and agents such as HSBC Issuer Services are at the heart of the entire process, and they are offering a real-value add to market participants.

Morgan Krone

5. How is HSBC Issuer Services helping its clients to navigate the reform?

Providers such as HSBC Issuer Services are working diligently with issuers and investors to ensure that legacy bond contracts are updated to take RFRs into account. “We are communicating with clients – including issuers and investors - about the transition and helping them amend their legacy contracts accordingly,” said McKay.

In addition to imparting on clients its extensive IBOR expertise, HSBC Issuer Services has been invited to participate in feedback forums with regulators, and actively engages with industry groups on the topic. This is vital in ensuring clients receive up-to-date and accurate information pertaining to IBOR reform. “Trustees and agents such as HSBC Issuer Services are at the heart of the entire process, and they are offering a real-value add to market participants,” said Krone.

Being key contractual parties across most relevant transaction documents, trustees and agents can indeed play a multifaceted, facilitator role between issuers and investors. “The transition gives us a unique ability to add value to our clients, by providing guidance in relation to the process required to move from forward looking rates to backward looking ones. As we will continue to operate the transactions going forward, we are keen to ensure that implementation of the new methodologies goes as smoothly as possible” said McKay.

6. How is technology shaping the transition process and further market developments?

Although financial institutions have been embracing new technologies over the past years, their adoption has been accelerated by COVID-19. Lockdown restrictions have forced bondholder meetings to move online, a transformation which has the potential to remain a permanent fixture even once the pandemic subsides.

“Virtual bondholder meetings necessarily became the norm, and they have proven efficient and arguably more straightforward than conducting meetings in person. I imagine virtual meetings will be a prominent optional feature of the future of bondholder meetings,” said McKay.

Elsewhere, technologies such as artificial intelligence (AI) and smart contracts – namely self-executing agreements – could also have helped expedite some of the more analogue aspects of the IBOR transition, which will be an important tool in facilitating a more efficient overall corporate action process and reduce risks for similar initiatives in future. “Bondholder consent processes – for example - have historically been paper-heavy so the introduction of smart contracts will facilitate efficiencies,” said Krone.

And although some of these new technological solutions will not be available in time to help with the immediate transition workflow, “when it comes to data treatment – and where it does not involve business decisions – HSBC and Allen & Overy are already using AI tools to review documents, extract information and auto-populate template notices and documents. We are committed to leveraging technology to overcome logistical problems, realise cost efficiencies and speed up the entire transition process,” said Krone.

"LIBOR is a complex and time consuming process, issuers and noteholders should act now to begin the process of contract amendment," concludes Tom McKay.

If a noteholder does not engage with other participants, then amendments cannot be considered at meetings, which is a market-wide risk.

Tim Bates

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For professional clients and eligible counterparties only.

1 RFRs are overnight rates based on actual transactions and reflect the average of the interest rates that certain financial institutions pay to borrow overnight on an unsecured basis from wholesale market participants (for unsecured RFRs, such as SONIA) or the average rate paid on secured overnight repurchase or “repo” transactions (for secured RFRs, such as SOFR). RFRs do not include or imply any credit or term premium of the type seen in LIBOR or EURIBOR. However, RFRs are not truly free of risk and can rise or fall as a result of changing economic conditions and central bank policy decisions.
2 Bank of England (May 2020) Interim Financial Stability Report May 2020

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