So, what exactly is happening to LIBOR? For years there have been talks about one of the most widely used interest rate benchmarks being phased out and replaced. The plan is for LIBOR to be fully phased out by 2023, but no new contracts using LIBOR will be issued beyond 2021. In this blog I’ll explain what LIBOR is, why it’s changing, and what clients can expect.
Why the Change?
The London Interbank Offered Rate is responsible for determining overnight borrowing costs for banks and is calculated from an average of global banks that participate in overnight lending to each other. It was established in the 1980s out of a need for more uniformity in interest rate products across the global financial community. LIBOR will be replaced with the Secured Overnight Financing Rate, or SOFR. The SOFR has been chosen as a replacement because instead of utilizing bank interest rate quotes for pricing, this index will use rates that investors offer for bank securities such as loans and assets backed by bonds. Therefore, instead of using estimated interest rates, this uses actual transaction rates found in the US Treasury market. This is important as some banks had been found to influence LIBOR for their own benefit in the past, and thus is one of many changes the financial services industry is experiencing in an effort to promote transparency in a post 2008 world.
What to Expect
While there are broader implications for certain complex financial products, in this blog I’ll focus on the average client that has likely held some form of debt based off LIBOR for pricing. Most institutions are working to make this transition as benign as possible, such that you will only notice a negligible difference in rates after SOFR takes effect. In addition, regulators are working to ensure the repricing is fair for everyone.
While LIBOR is comprised of many global banks with different underlying currencies, SOFR is a US dollar denominated benchmark. As of now we can expect this to be used in the US and UK, but participation beyond that remains to be seen as other countries explore what their preferred interest rate benchmark will be.
If you currently have debt linked to LIBOR, you will undoubtedly receive ample notice about changes being made to your account so that you are not surprised to see the loan terms change. While the changes may be modest, it is always good practice to review your debt with your financial advisor periodically to ensure you are in the product that is right for you.
Kristina Mello, MBA serves as Financial Planner and Advisor at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at kmello@strategicpoint.com.
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