LIBOR to SOFR: A Long-Anticipated Transition

While much has been made of the cessation of LIBOR (London Inter-Bank Offered Rate) on Dec. 31, 2021, we believe any disruption by the switch to SOFR (Secured Overnight Financing Rate) as the new ARR (Alternative Reference Rate) will be limited.

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The market is prepared for the change, and since existing contracts can still quote LIBOR, we do not believe any systemic risks will materialize from this long-awaited transition.

Why is LIBOR being phased out?

  • LIBOR has been the most widely used interest-rate benchmark to price or value a wide range of financial products, with underlying transactions of over $370 trillion worldwide.
  • Since LIBOR is based on estimates quoted by a panel of banks, the rate has become vulnerable to manipulation through a lack of transparency.
  • To address the problem, LIBOR is being phased out over the next few years. After Dec. 31, 2021, ICE Benchmark Administration (IBA) will stop publishing all non-USD LIBOR rates and some USD LIBOR rates.
  • While existing contracts or securities that reference LIBOR may continue to use LIBOR, no new contract or security may reference LIBOR as its reference rate after Dec. 31.

What is replacing LIBOR?

  • Beginning in 2016, the Federal Reserve Bank of New York Fed convened the Alternative Rates Reference Committee (ARRC), a group of private-market financial leaders, to help facilitate the transition from LIBOR. The ARRC identified SOFR as the rate that represents best practices for use in certain new USD derivatives and other financial contracts.
  • SOFR is based on transactions in the Treasury repurchase market and is seen as preferable to LIBOR since it is based on data from observable transactions rather than estimated borrowing rates.
  • To support the transition to SOFR, the ARRC developed the Paced Transition Plan, with specific steps and timelines designed to encourage adoption of SOFR. The daily transaction volumes underlying SOFR are usually around $1 trillion.

How has Pacific Asset Management planned for this transition?

  • We established an internal LIBOR Working Group to ensure all exposures specific to the firm’s business have been identified and remediated before the transition.
  • Operationally, our firm’s systems and service providers have been evaluated and updated where necessary to ensure continuity with the LIBOR-SOFR transition or the use of other alternative rates.
  • For now, expectations are that loans issued in 2022 will be tied to a new alternative rate, primarily SOFR. We’ve already seen recent new issues proactively address this using SOFR as the alternative reference rate. There has been no material impact to the loan asset class for these first-to-market SOFR-linked issues.
  • Because SOFR rates are generally lower than LIBOR, loans that have recently come to market have added a credit-spread adjustment or simply increased the discount margin (spread). Either way, the impact has been de minimis to the yield investors receive on loan investments.

How does the new reference rate affect our risk assessment?

  • There’s no material impact to the risk assessment of our holdings.
  • – 1-week and 2-month LIBOR rates will be discontinued on Dec. 31; all of our current holdings with these reference rates mature on or prior to that date. For new holdings, we will review the LIBOR fallback language when evaluating for purchase. Historically, limited bank-loan issues have referenced these two LIBOR rates.
  • – Loans with 1-, 3- and 6-month LIBOR reference rates will also no longer be issued after Dec. 31. However, they will continue to be quoted for at least 18 months. We will continue to monitor our holdings and industry developments related to the reference rates on these positions. The significant majority of bank-loan issuers reference 1- and 3-month LIBOR rates.
  • The risk approach on new positions issued with an alternative reference rate such as SOFR will not differ materially from the process for loans that referenced LIBOR.
  • Additionally, at current rates, the impact of an alternative reference rate is small as most loans have LIBOR/SOFR floors for reference rates.

Definitions

The Alternative Reference Rates Committee (ARRC) is a group of market participants and official-sector entities convened by the U.S. Federal Reserve Board to help ensure successful adoption of its recommended alternative, SOFR and improved IBOR fallbacks.

LIBOR (London Interbank Offered Rate) is the benchmark reference for interest rates that banks charge each other for debt instruments and loans.

SOFR (Secured Overnight Financing Rate) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

About Principal Risks: Past performance does not guarantee future results. All investing involves risks including the possible loss of the principal amount invested. There is no guarantee the Funds will achieve their investment goal. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities. The Funds are subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default).High-yield/high-risk bonds (“junk bonds”) and floating rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. The Funds are also subject to foreign-markets risk.

Pacific Asset Management LLC is the sub-adviser for the Pacific Funds℠ Fixed Income Funds. The views in this commentary are as of Dec. 16, 2021 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.

Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.

Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or summary prospectus contains this and other information and should be read carefully before investing. The prospectus can be obtained by visiting PacificFunds.com.

Pacific Funds is a registered service mark of Pacific Life Insurance Company (“Pacific Life”). S&P is a registered trademark of Standard & Poor’s Financial Services LLC. All third-party trademarks referenced by Pacific Life, such as S&P, belong to their respective owners. References of third-party trademarks do not indicate or signify any relationship, sponsorship or endorsement between Pacific Life and the owners of referenced trademarks.

Pacific Funds are distributed by Pacific Select Distributors, LLC (member of FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.

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