Author: Esther Carenza
Liability Swap
A liability swap is a derivative agreement/contract where two parties exchange their interest or currency exposure to a liability.
Asset Swap
An asset swap has terms and structure of a liability swap, but it exchanges exposure to an asset.
Inflation Swap Option
An inflation swap option, involves an option where a party pays a fixed rate cashflow on a notional principal amount and another party pays a floating rate associated with the inflation index like the Consumer Price Index (CPI).
Credit Default Swap Option
A credit default swap option, offers the holder the right, but not the obligation to buy (call) or sell (put) protection on a particular future time period for a specific spread.
Commodity Swap Option
A commodity swap option is an agreement allowing the option buyer the right, without obligation, to buy or sell an underlying asset, a commodity. Commodities include agricultural products (grains: wheat, rice), sugar, precious metals, or oil at a designated price until a designated date.
Equity Swap Option
An equity swap option, is an option where two parties enter into a financial derivative contract to exchange returns on a stock or equity index with another cashflow, fixed rate of interest/reference rates like LIBOR.
Overnight Indexed Swaps
An overnight indexed swap is an interest rate swap with a periodic floating payment in general derived from a return on calculated from a daily month compound interest investment.
Interest Rate Options
An interest rate option, similar to an equity option, is a financial derivative, allowing the owner to benefit from changes in interest rates.
Interest Rate Cap
An interest rate cap is a kind of interest rate derivative whereby the purchaser receives payments at the end of each period in which the interest rate is higher than the agreed strike price, the fixed price at which the option holder can buy or sell, the underlying security or commodity. An agreement to receive a payment monthly above 2.5 percent of the LIBOR rate is an example of a cap.
Interest Rate Floor
An interest rate floor is an agreed-upon rate in the lower spectrum of rates related to a floating rate loan product, usually used in adjustable-rate mortgage.
Commercial Area Products
Commercial area products are floating rate notes, floating rate certificates of deposit, syndicated loans, variable rate mortgages and term loans.
Floating Rate Notes
Floating rate notes are bonds that have a variable coupon – a debt security maturing every week with the principal reinvested at a new interest rate, which is reset at a fixed spread over a reference rate – equal to a money market reference rate, such as LIBOR with a quoted spread (quoted margin). A considerable part of the U.S. and UK investment grade bond market, floating rate notes allow investors to have the advantage of a rise in interest rates as the rate on the floater adjusts from time to time to current market rates. It may difficult to purchase a floating rate note individually, but can be done so through a mutual fund, a portfolio of stocks, bonds or other securities or exchange traded fund, an investment fund traded on stock exchanges like stocks.
Floating Rate Certificates of Deposit
A floating rate certificate of deposit is a financial instrument with a fixed term and a floating interest rate, paid periodically derived from a particular benchmark or reference rate, LIBOR.
Certificates of deposit are beneficial for individuals seeking a way to save money at the same time earning a relatively high interest. These certificates have the disadvantages of cash tied up, missing out on other investments and risk of inflation.
Syndicated Loans
Two or more lenders jointly providing loans for one or more borrowers on the same loan terms and with different duties and sign the same loan agreement is a syndicated loan. Often, one bank is appointed as the bank agent to manage the loan business on behalf of self-organizing group of individuals, companies, corporation or entities.
Variable Rate Mortgages
A variable rate mortgage, known as adjustable rate mortgage or tracker mortgage, is a mortgage loan with the interest on the note periodically adjusted at a level above a particular benchmark or reference rate, LIBOR + 2 points.
Term Loans
A term loan is a loan issued by a bank for a fixed amount and is repaid in regular payments over a set period of time, usually between one and ten years, however may be extended as long as thirty years in certain cases.
Hybrid Products
Range accrual, step up callable, target redemption, and hybrid perpetual notes and collateralized mortgage and collateralized debt obligations are hybrid products.
Range Accrual
In finance, a range accrual is a structured product where the coupon is linked to the performance of a reference index. The initial coupon is usually above market price and is based on a formula on the underlying index, LIBOR.
Step Up Callable
Step up securities, investment securities, are usually structured to be callable by the issuer at pay an initial interest rate on a given date or dates, known as the call dates, before maturity at say for example, three month, LIBOR.
Target Redemption
A target redemption note is an index linked note having inverse floating rate notes, providing a guaranteed sum of the coupons (target cap) offering early termination. Usually, coupons are calculated based on an inverse floating LIBOR/EURIBOR formula.
Hybrid Perpetual Notes
Hybrid perpetual notes are a combination of features of bonds and shares that have no final maturity, but an issuer may prefer to redeem them after a specified time period.
Collateralized Mortgage
Collateralized mortgage refers to a kind of mortgage-backed security that comprises a pool of mortgages grouped together and sold as an investment.
Collateralized Debt Obligations
Collateralized debt obligations, originally developed as instruments for the corporate debt markets, is a kind of structured asset-backed security because senior tranches pay a spread above LIBOR even though they have AAA-ratings.
Lowering borrowing costs appears to be attractive, however, not everyone benefits from LIBOR.
Since the financial crisis in 2008, banks no longer fund themselves in this manner. Without an underlying active market means LIBOR is, and has been, sustained by expert judgment, which cannot continue indefinitely. LIBOR based loan products are no longer offered since September 2020 and LIBOR will cease to be used after the end of 2021.
SONIA introduced in March 1997, was not put into effect by the Bank of England until 2016. The Bank of England takes responsibility for its governance and reports an interest rate every London business day. The Sterling Overnight Indexed Average (SONIA) is the effective overnight interest rate that is calculated using an average of the past day’s Sterling-denominated deposit transactions paid by banks for unsecured transactions in the British sterling market. The SONIA daily interest rate values through a relevant interest period are compounded with the calculated rate set a few days before the payment date in order to allow for the payment to be known and settled. Since there is a time delay between the rate becoming available and the time it is due, compounded SONIA will not be the preferred interest rate for particular borrowers and transactions. A significant factor for smaller corporate entities, wealth, and retail establishments is the desire to know their payments with certainty (no hedging and not multi-currency). The Term Sonia Reference Rate (TSRR) may be one of the preferred rates due to its forward-looking term reference rate based on overnight SONIA indexed swap data. FTSE Russell (a British provider of stock market indices and related data services, wholly owned by the London Stock Exchange and operating from Canary Wharf), ICE Benchmark Administration, Refinitiv (the financial and risk business is as a result of the closing of the strategic partnership transaction between Thomson Reuters and private equity funds managed by Blackstone) and IHS Markit (team of more than 5,000 analysts, data scientists, financial experts and industry specialists) worked on the development of the TSRR, receiving remarkable attention in the loan market with the hope it will be a lower risk alternative to LIBOR.
Compounded SONIA depends on a method of compounding interest to calculate SONIA over a longer interest period.
Export finance, a contract between an importer and exporter, and emerging market loans use trade and working capital products with forward discounted cash flows and interest rates, which allow more time to make interest payments.
Particular legacy LIBOR transactions will remain the same because if they were to change to Compounded SONIA, it would be too complex, or given the remaining time frame, not be cost effective.
The UK authorities have made it clear that TSSR will be used in a limited fashion with the preference for a broad based transition to Compounded SONIA.
The regulators recognize Compounded SONIA has benefits over TSSR in the following ways.
Compounded SONIA has the ability to perform effectively even though its variables and/or assumptions are altered over TSSR.
It is used more often in the derivatives market.
As of July 2020, Compounded SONIA became the norm for sterling denominated floating rate notes (FRNs) with the implication that Compounded SONIA can be used regularly across the derivatives, bonds, and securitisation markets.
Compound-in-arrears rates are now available in all currencies where a risk free rate (RFR) is available.
Bond Contracts Transitioning from LIBOR Referencing Bonds
Certain outstanding bond contracts, referencing Sterling LIBOR are due to mature after the end of 2021. These legacy bonds are required to make the transition to a SONIA-based reference rate. Failing to undergo transition, these legacy bonds may adversely affect the bond. Numerous legacy bond contracts have a fallback to a fixed rate if a floating rate cannot be determined. With this, there will be contract uncertainty and risk of litigation.
The RFRWG considers that the mostly orderly transition from LIBOR to SONIA is floating rate bond contracts to substitute or change these contracts before LIBOR is no longer in use or declared by the regulators to no longer be representative. Consent solicitation is the manner in which to amend the bond conditions with the consent of the bondholder. Unless consent solicitation is explicitly indicated for the bond terms and conditions, there are no mandatory terms.
With the current consent solicitations, the interest rate provisions have been amended to reference SONIA compounded daily in arrears plus a fixed spread adjustment, taking into consideration the difference in value of LIBOR and SONIA basis swaps over a period of time and adds this to the original margin of the bond.
LIBOR permeated every corner of the lending market in England and internationally. It was the main rate for the U.S. since London, is after all, one of the leading global financial centres around the world. The LIBOR benchmark rate underpinned huge numbers, trillions of pounds/dollars of contracts internationally. Despite the challenges in the transition, SONIA will prevail by the end of 2021.
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