T. ROWE PRICE INSIGHTS ON FIXED INCOME

LIBOR Is Changing: Five Things You Need to Know T. Rowe Price’s working group considers the implications of the transition away from LIBOR. November 2019

KEY INSIGHTS Jeff DeVack ■■ Financial authorities are planning for the phaseout and replacement of the Fixed Income Portfolio Specialist London Interbank Offered Rate (LIBOR) after the end of 2021 with new alternative reference rates. Mike McGonigle Director of Credit Research ■■ The transition to a new benchmark rate would impact a wide range of global assets. Close coordination among different institutions aims to minimize disruption. Predrag Rogic Senior Legal Counsel and ■■ T. Rowe Price has created a dedicated working group to assess our portfolio Head of Legal Capital Markets exposures to LIBOR and help smooth the transition of our clients’ investments to new benchmark arrangements. Doug Spratley Head of U.S. Fixed Income Trading– Money Markets lobal financial markets are ■■ Declining Rate of Interbank preparing for the replacement Borrowing: LIBOR is set based on Gof the London Interbank the average rate at which major global Offered Rate at the end of 2021. banks lend money to one another on For decades, LIBOR has served as a daily basis. Since the global financial a benchmark rate for a wide array of crisis, actual lending between banks global financial products in five major has fallen, with the effect that LIBOR currencies. The planned transition to is now based on an increasingly small new benchmark interest rates could number of real‑world transactions. significantly impact market pricing and processes in several asset classes, ■■ Falling Market Trust: Incidences of with estimates of total LIBOR exposure LIBOR manipulation, while small in globally running in the hundreds of number, have generated controversy trillions. T. Rowe Price’s working group in recent years. Only a select group on the LIBOR transition answers some of banks is responsible for reporting important questions on the transition the rates at which they lend to and how we’re managing it. one another on a daily basis. The controversy related to instances where Q. Why is LIBOR being replaced? some banks intentionally misreported the rates, which impacted the level at Jeff DeVack: There are a number of which LIBOR was set and weakened reasons why markets are transitioning the market’s trust in it as a benchmark. away from LIBOR, including the following:

1 New Benchmarks Are Set to Replace LIBOR The ARRs feature key differences to LIBOR W IOR W IOR

Benchmark interest rate used in wide range New alternative reference rates (ARRs) as soon of global financial products as 2021

Requires major global banks to self-report ARRs will be based on real-world, the rate they would make short-term loans verifiable transactions to other banks

Set daily in five major currencies across Different rates planned for major currencies: a range of maturities USD‒Secured Overnight Financing Rate (SOFR) GBP‒Sterling Overnight Indexed Average (SONIA) EUR‒Euro Short-Term Rate (ESTER) CHF‒Swiss Average Rate Overnight (SARON) JPY‒Tokyo Overnight Average Rate (TONA)

■■ LIBOR Sustainability in Question: In the U.S., the planned ARR for Regulatory bodies have subsequently dollar‑denominated assets is the increased scrutiny of LIBOR‑reporting Secured Overnight Financing Rate banks. Many banks have been less (SOFR), which is based on overnight willing to continue to submit interbank loans in the U.S. Treasury repurchase lending rates amid the shifting (repo) market. UK authorities have regulatory environment, committing identified the Sterling Overnight only until the end of 2021. As there is Indexed Average (SONIA) as the no obligation for them to continue after LIBOR replacement, while the this time, LIBOR may simply not be Euro Short‑Term Rate (ESTER) is available from the beginning in 2022. the planned replacement for the eurozone. Elsewhere, the Swiss Q. What will replace LIBOR? Average Rate Overnight (SARON) rate will be used for Swiss francs and Mike McGonigle: Central banks and the Tokyo Overnight Average Rate financial regulators are focusing on (TONA) will be used for the yen. The constructing alternative rates to replace specifics governing these ARRs will be LIBOR. The plans are to shift to overnight important to understand how different and risk‑free benchmark rates, known as asset classes and individual securities alternative reference rates (ARRs), in each will be impacted by the transition. of the five currencies currently covered by LIBOR. The priority is to ensure that Q. How will the transition from LIBOR the ARRs comply with International impact markets? Organization of Securities Commissions (IOSCO) standards. This means the Doug Spratley: Of the roughly USD new rates must be based on real‑world, 340 trillion1 worth of assets based on verifiable transactions rather than more interbank offered rates, securities that subjective quotes that could potentially are priced against the LIBOR benchmark be manipulated. rate will be directly impacted. In addition

1 Source: U.S. Federal Reserve research.

2 to developing the ARRs, global central that pre‑date the new ISDA definitions banks in conjunction with industry will be amended by market‑wide Since the global groups are working on a credit spread ISDA protocols. to help markets calculate the bank credit financial crisis, premium,2 which is a component of Q. What are the challenges to actual lending LIBOR but not of the ARRs. Applying the transition? this premium would help ease the Predrag Rogic: Significant work still between banks conversion of existing LIBOR exposures needs to be done due to the high to ARRs to avoid market disruption and volume of global assets that reference has fallen, with the pricing discrepancies. LIBOR with new issuance ongoing. Any effect that LIBOR Specific asset classes will require uncertainty regarding the new ARRs is now based on different steps to ensure securities do could result in pricing volatility during not become untradeable or experience the transition process, which would an increasingly high degrees of pricing volatility: mean significant value transfers across global markets. small number Loans: In many areas of the of real‑world loan market, recent loan Central banks, regulatory bodies, and documentation often incorporates other financial institutions globally are transactions. language being developed by the Loan working to encourage the adoption of Syndications and Trading Association the new ARRs ahead of time to ensure — Jeff DeVack and other trade groups. Many leveraged market participants understand the Fixed Income Portfolio Specialist loans also typically include built‑in new system and trust it as a reliable alternative rates. However, many of these benchmark. However, the lack of an are intended for periodic outages of international central authority could LIBOR rather than a permanent cessation. make coordination difficult.

Bonds and Asset‑Backed In addition to providing benchmark Securities: Existing bonds and rates for five major currencies, LIBOR asset‑backed securities form a challenge is available in seven different maturities, as they often require the consent of a creating a curve for markets to use majority of holders to change the as a benchmark out to 12 months. underlying benchmark interest rates. Therefore, authorities are considering These asset classes may require constructing forward‑looking term rates case‑by‑case negotiations and solutions based on the ARRs. A liquid curve on alternative rates. based on real‑world transactions is an important tool to help prevent volatility Derivatives: LIBOR is used in during the transition. the pricing of, and as a reference rate in, a wide range of Newly issued securities will need derivatives contracts. Authorities are to include recommended language working to generate a liquid derivatives that reflects the new benchmark. All market for hedging exposures to the changes also need to be clearly and new ARRs. In addition, the widely communicated to market International Swaps and Derivatives participants both large and small. Association (ISDA) is changing the Q. What is T. Rowe Price doing to applicable definitions for interest rate prepare for the transition? derivatives currently referencing LIBOR and other interbank rates to create a Mike McGonigle: Our primary aim is fallback to the ARRs in the event to keep any disruption to our clients’ LIBOR is discontinued permanently. investments to a minimum. T. Rowe We expect that derivatives contracts Price has set up a dedicated working

2 Bank credit premium is the excess return that compensates for the risk a bank could default.

3 group to manage the shift from LIBOR legal agreements to reflect the new to the new ARRs. The working group post‑LIBOR protocols. We are also ...we will prioritize consists of senior members from aware of LIBOR risks embedded in across T. Rowe Price’s business units any new deals and have incorporated pursuing the best and is focused on the following: these transition risks into our outcome for our investment selection process. Overall, 1. LIBOR exposure analysis: Work we will prioritize pursuing the best clients during the is underway to determine the outcome for our clients during the extent of exposures to investments transition while also maintaining our transition while referencing LIBOR or other focus on their long-term investments also maintaining interbank offered rates across all under the new ARRs. T. Rowe Price‑managed portfolios. our focus on The group can then assess how 3. Communication: Communication the transition from LIBOR to ARRs and engagement with internal their long-term could impact clients’ investments in and external partners are key. Our investments under different portfolios. working group is directing external communications with investors as the new ARRs. We are reviewing all legal agreements well as other market participants on investments in LIBOR‑referencing to ensure transparency about the — Mike McGonigle securities. This will help us gauge process and the timing of the Director of Credit Research how a change in the underlying transition. The group is in contact interest rate will impact markets down with regulators to stay informed to the level of individual holdings. about the formulation of the ARRs.

2. Transition management: Planning Investors need to be prepared for a is in progress to ensure a successful post‑LIBOR era in a little more than two transition from LIBOR to the ARRs. years’ time. T. Rowe Price has dedicated As the new framework for the ARRs resources and an action plan in place emerges, the group will implement to help ensure client portfolios are well its plan for navigating the shift. This positioned to adjust to the impending includes managing and adjusting LIBOR replacement developments. exposures to investments affected by the new ARRs as well as updating

WHAT WE’RE WATCHING NEXT We have dedicated research groups looking at how the LIBOR transition will impact each individual asset class, including leveraged loans, collateralized debt obligations, securitized products, corporate bonds, and municipal bonds. The research groups will report on developments of new ARRs as well as the legal language related to the transition from LIBOR to the new rates. Based on these findings, the teams will devise plans on how we can mitigate risks and prepare for the transition on a portfolio‑level basis.

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Important Information This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are those of the authors as of November 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates. This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only. T. Rowe Price Investment Services, Inc. © 2019 T. Rowe Price. All rights reserved. T. Rowe Price, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.

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