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Year-long effort to replace Libor in bonds may reward banks

The Bank of England(above) is championing the Sterling Overnight Interbank Average, or Sonia, as an alternative because it tracks the rates of actual overnight funding deals and is therefore considered harder to manipulate.

[LONDON] It took a full year for banks to design and sell a bond tied to the UK's replacement for Libor. Now the pioneers of that deal are preparing to use it as a model for a much broader client base.

They may have uncovered a lucrative opportunity. Such was the strength of demand when the European Investment Bank sold the Sonia-linked notes last month that it was able to raise £1 billion (S$1.8 billion), from a mooted target of at least £250 million. Order books on the deal, which was arranged by HSBC Holdings Plc, NatWest Markets, Royal Bank of Canada and TD Securities Inc, closed above £1.55 billion. The securities strengthened in the secondary market after the sale.

"We have a template," said Mark Byrne, director of syndicate at TD Securities, one of the first two banks brought in to conduct the EIB bond sale. "We can take, for the most part, what the EIB has done, and use it for other issuers willing to follow suit."

Nobody is saying the bond pipeline will immediately swell to bursting point. But more deals seem inevitable, given a global regulatory effort to shift pricing away from the London Interbank Offered Rate, known as Libor, after it emerged some lenders had been attempting to rig the gauge for years. The Bank of England is championing the Sterling Overnight Interbank Average, or Sonia, as an alternative because it tracks the rates of actual overnight funding deals and is therefore considered harder to manipulate.

It would be a welcome trend for bank syndicates that are seeking ways to boost revenue in fixed income, currencies and commodities amid a slowdown in trading. Adding to their woes, sales of high-grade corporate bonds in Europe fell 30 per cent to £149 billion in the first half. In contrast, sterling floating-rate issuance enjoyed the best opening half since 2009, with £22 billion of the securities priced, Bloomberg data show.

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The Sonia benchmark ought to replace Libor as "the norm" on floating-rate notes by 2019, said Asif Sherani, co-head of SSA and FIG DCM syndicate at HSBC, who helped arrange the EIB issue. "We are definitely pitching this to clients to make sure they understand how Sonia-linked floaters work," he said.

That'll be music to the ears of regulators, including the BOE's Mark Carney, who have been warning of the challenges posed by a migration away from Libor, which still underpins US$370 trillion of instruments across various currencies. Officials said last year they'll stop compelling banks to submit Libor quotes after 2021.

"Market participants in every sector and market that use Libor now need to come together to identify and resolve issues, change business practices, and adopt alternative benchmarks," Mr Carney said at a conference in London in May. A reformed Sonia now forms the basis for £50 billion of transactions a day, he said, adding that he expected floating-rate bonds and loans using the benchmark to appear.

New York Federal Reserve President Bill Dudley called the shift away from Libor a "clear risk to financial stability" and a "monumental and complicated effort" that will "entail overcoming many obstacles."

Nonetheless, minutes from the latest industry-led working group on sterling risk-free reference rates released on Wednesday show members believe a "robust" term Sonia rate "could facilitate benchmark transition for an important set of end users," particularly in loan and debt capital markets.

The EIB notes, the first benchmark-sized securities tied to Sonia, took longer than usual to arrange. Computer systems and models needed to be adapted to support the pricing structure because interest on the Sonia-linked securities will be compounded daily. Such minutiae may slow the deal flow for other issuers.

Due to the complexity of the arrangements, "I don't think there's a trade due to happen" in the coming weeks, TD Securities' Byrne said. But an outline for future deals and a "realistic alternative" to Libor-linked floating rate note deals is now in place, which banks will probably join the supranational EIB in using. "I wouldn't be surprised to see covered bonds move this way at some point as well," he said.

The EIB's deal has made a winning start, with the notes' spread tightening about two and a half basis points to around 32.5 basis points since pricing on June 22, according to Bloomberg data.

In the US, Libor's administrators are fighting to preserve its status as the premier global benchmark for dollar-based assets with a shift to a so-called waterfall methodology. Investment-grade corporate bond sales in the U.S. so far this year have reached US$640 billion, down 10.4 per cent on the US$714 billion raised in the first half of 2017, data compiled by Bloomberg show.

Even "issuers based in the US that won't ever actually do a sterling trade" paid attention to the EIB sale, Mr Byrne said. They are "looking to see what they can learn from this for any future potential non-Libor FRNs in other markets."


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