Libor Cessation Impact on Uk Pension Schemes

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FOR ISSUE IN THE UK AND EU. FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY. NOT TO BE REPRODUCED WITHOUT PRIOR WRITTEN APPROVAL. PLEASE REFER TO ALL RISK DISCLOSURES AT THE BACK OF THIS DOCUMENT.

MARCH 2021 MARKET UPDATE: LIBOR CESSATION IMPACT ON UK PENSION SCHEMES

WHAT HAS BEEN ANNOUNCED IN RELATION TO THE CESSATION OF LIBOR AND WHAT DOES THIS MEAN FOR UK PENSION SCHEMES? • LIBOR for several currencies, including all GBP tenors, will end WHAT IS THE IMPACT ON LIBOR SWAPS? from 1 January 2022. GBP LIBOR will be replaced by SONIA plus a fixed spread (e.g. 0.2766% for 6-month GBP LIBOR) Derivative markets have sought to price the spread between LIBOR and SONIA since the intention to cease publication was • The announcements mark an important final step in the first suggested in 2017 (see Figure 1). There has been greater successful transition away from LIBOR in derivative markets, certainty since late 2019, when results of an International Swap which is consistent with what Insight advocated for in order and Derivatives Association (ISDA) consultation into a fallback to protect its clients mechanism were published, agreeing the calculation • The announcement will have minimal impact on most pension methodology as the five-year median difference between LIBOR schemes’ liability hedging portfolios and SONIA. WHY IS LIBOR ENDING? On 23 October 2020, ISDA launched its 2020 IBOR Fallbacks Protocol, effective on 25 January 2021: The London Interbank Offer Rate (LIBOR) represents a series of • Where both counterparties have signed up, once LIBOR interest rates, available across different currencies and tenors, ceases, existing LIBOR swaps will change to SONIA +X based which has been important both in the UK and globally. The rates on a 5-year median difference between realised LIBOR and are calculated based on polling banks on the cost of interbank SONIA lending, which led to a major scandal during the 2007/2008 financial crisis that led to huge bank fines and a closer look as to • This means remaining LIBOR swaps effectively become SONIA how benchmarks are administered and regulated. positions with a different fixed rate

In July 2017, Andrew Bailey in his role as the head of the UK’s • The Protocol has been adopted by Insight for its agency Financial Conduct Authority (FCA) implied that IBORs (in all documentation and by all ISDA counterparties currencies) would not be sustained after end-2021. The end date for the 5-year lookback period for the calculation LIBOR will be replaced by new reference interest rates calculated was agreed to be the earlier of: based on actual transactions. For the UK, the new interest rate is 1. ICE Benchmark Association (IBA) announcing it will stop the Sterling Overnight Index Average (SONIA). publishing certain LIBOR tenors/currencies (permanent Figure 1: The market has priced in the expected LIBOR cessation), or cessation 2. the FCA announcing that a LIBOR rate is no longer representative and should not be used beyond a certain date 0.40% (pre-cessation). 0.30% WHAT HAS BEEN ANNOUNCED?

0.20% On Friday 5 March 2021, the IBA announced it will cease publishing the following:

0.10% • From 31 December 2021: all pound sterling (GBP), euro (EUR), Swiss franc (CHF) and Japanese yen (JPY) LIBOR rates; as well 6 - monthLIBOR - SONIA basis (%) 0.00% as 1-week and 3-month US dollar (USD) LIBOR 2013 2015 2017 2019 2021 30-year SONIA 6-month LIBOR swap basis • From 30 June 2023: all remaining US dollar LIBOR settings SONIA-LIBOR ISDA Protocol fallback adjustment Later the same day, ISDA announced that IBA’s statements constitute an ‘index cessation event’ under the Protocol. The Source: Bloomberg as at 5 March 2021 ISDA statement confirmed that the spread adjustment would use

a 5-year median window ending 5 March 2021, applying from CROSS-CURRENCY BASIS SWAPS the point at which LIBOR becomes discontinued or non- representative. While trading in GBP interest rate swaps has largely moved to SONIA already, cross-currency basis swaps remain This means, for example, that interest rate swaps referencing 6- predominantly LIBOR based. The delay is driven by the lower month GBP LIBOR will continue as usual until 31 December 2021; liquidity in the EUR and USD risk-free-rate (RFR) markets. As a and become SONIA +0.2766% thereafter. For 3-month LIBOR the result, banks are seeing an increased number of enquiries for fixed rate will be SONIA +0.1193%. SONIA vs USD LIBOR cross-currency swaps.

WHAT IS THE IMPACT ON LIABILITY HEDGING? The target is to end GBP LIBOR-based cross-currency basis swaps by the end of Q3 2021, which is likely to accelerate the The announcement will have minimal impact on most pension move to RFR-based cross-currency swaps. One bank estimated schemes’ liability-hedging portfolios. From 2022, any LIBOR that 40% of GBP cross-currency swaps will be SONIA by the start swaps will effectively become SONIA plus a fixed spread and of Q3 2021, but it is not yet known what USD rate will be used continue to be managed to meet your objectives. (i.e. SONIA vs SOFR or SONIA vs USD LIBOR). Insight is very pleased with the outcome for UK pension REPLACEMENT RATES FOR OTHER CURRENCIES schemes, having advocated for reform on the lines of what has been agreed in order to protect our clients as users of such We include below a short summary of the replacement RFRs for 1 derivatives. In comparison, other possible approaches to LIBOR other currencies affected by the announcement (see Table 1). reform could have exposed pension schemes to material price uncertainty or the cost of being forced to unwind positions with Regarding liquidity across the GBP, EUR and USD markets: banks at potentially less favourable pricing. • While banks are already seeing good liquidity in SONIA swaps, SYNTHETIC LIBOR this is much less so in ESTR and SOFR. • In terms of EUR swaps, liquidity remains greatest for EURIBOR The FCA will consult on the use of synthetic LIBOR after the swaps, with EONIA liquidity lagging and ESTR liquidity much cessation of LIBOR for the most commonly used tenors. In order lower. to facilitate this, the government is legislating to give the FCA powers to compel IBA to publish synthetic LIBOR. Table 1: Replacement RFRs for currencies affected by the recent announcement Under the proposals, synthetic LIBOR would be a rate published by IBA aimed at ‘tough legacy’ contracts, such as certain bonds Rate Replacement RFR or loans, that could not be transitioned prior to the cessation USD LIBOR SOFR (Secured Overnight Financing Rate) date. This will involve a new methodology (likely to be a forward- EUR LIBOR* ESTR (Euro Short-term Rate) looking SONIA +X calculation), which would be for 1-month, 3- CHF LIBOR SARON (Swiss Average Rate Overnight) month and 6-month GBP LIBOR. JPY LIBOR TONA (Tokyo Overnight Average) Synthetic LIBOR is not therefore expected to feature materially * While EUR LIBOR will cease, the Euro Interbank Offer Rate (EURIBOR) will remain in existence under a reformed approach. Euro Overnight within UK pension schemes’ liability-hedging portfolios. Index Average (EONIA) is expected to become ESTR.

IMPORTANT INFORMATION

RISK DISCLOSURES Investment in any strategy involves a risk of loss which may partly be due to exchange rate fluctuations.

Institutional Business Development Consultant Relationship Management @InsightInvestIM [email protected] [email protected] +44 20 7321 1552 +44 20 7321 1023 company/insight-investment European Business Development [email protected] www.insightinvestment.com +49 69 12014 2650 +44 20 7321 1928

1 For more information on Insight’s engagement, please see: https://www.insightinvestment.com/globalassets/documents/regulatory- updates/uk-helping-clients-prepare-for-the-transition-away-from-libor.pdf

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