Libor's an Unkillable `Cockroach' Because Credit Risk Is No Bug

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(Bloomberg) -- Being called a “cockroach” might not bother Libor too much.

That’s how Canaccord Genuity analyst Brian Reynolds described the scandal-ridden London interbank offered rate, the peg for $370 trillion in financial products. It’s supposed to be slowly ceding its crown as best of the benchmarks to the Secured Overnight Funding Rate, or SOFR.

But rumors of Libor’s death have been greatly exaggerated, the analyst contended in a note Tuesday, citing a seemingly perverse reason it will persevere. Namely, he wrote, its credit component might be viewed more as a feature than a bug:

“We call Libor a cockroach because it is not going to go away even though equity investors despise it and regulators want to kill it. It is not going away because fixed-income portfolio managers love it. They love it because it is the only interest rate that goes up in a crisis, allowing managers who own floating rate debt based on it to outperform in difficult times because of exposure to corporate credit. Wall Street is in the business of supplying what the customers want, so the Street will continue to serve up products that are tied to Libor.”

Libor is an unsecured rate banks charge each another for short-term loans. Meanwhile, SOFR is based on transactions collateralized by Treasuries and doesn’t share this credit component, as David Bowman, special adviser to the board of governors at the Federal Reserve has noted.

Reynolds highlighted the 1987 stock market crash, the dot-com meltdown at the start of the millennium and the 2008 financial crisis as instances when the credit risk embedded in Libor helped boost fixed-income returns -- when SOFR wouldn’t have behaved in such a fashion.

“We can think of no reason why fixed-income investors would want to switch their existing bonds from Libor to SOFR, giving up the prospect of outperforming a financial crisis,” the analyst added, positing that such fund managers will demand a premium for migrating that neither the Fed nor issuers would be willing to reward them with. “The notion that investors would want to switch to SOFR is another example of well-intentioned regulators coming up with rules that make no sense from a real-world perspective.”

To be sure, the potential for a complete phase-out of Libor after 2021, given the regulatory and institutional heft behind SOFR, might prompt investors to get ahead of what’s been billed as an inevitability. Indeed, trading volumes in overnight index swaps have already risen to match and even run ahead of those of Libor-linked interest-rate swaps. However, the Intercontinental Exchange’s development of a new methodology for calculating Libor has some sell-side strategists speculating about life after 2021. And SOFR’s missteps out of the gate haven’t helped it gain the trust of market participants, either.

To paraphrase what former Andrew Jackson once reportedly said about a Supreme Court decision he opposed: Regulators have made their decision on Libor’s replacement; now let markets endorse it.

©2018 Bloomberg L.P.

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