Why there's an urgency to use fallback language in Libor contracts

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Priya Misra, managing director and global head of rates strategy at TD Securities, said the immediate issue for the municipal bond market is dealing with its legacy book of derivatives and its legacy book of cash bonds.

The Internal Revenue Service will not treat certain fallback language as a material change to a contract referencing Libor or other interbank offered rates.

The IRS made that official in Revenue Procedure 2020-44 earlier this month, announcing that fallback language released by the International Swaps and Derivatives Association as well as the Alternative Reference Rates Committee can be used.

The Revenue Procedure applies to contracts entered on or after Oct. 9 through Dec. 31, 2022, and is also retroactive for modifications to contracts entered into prior to October 9.

The need to incorporate this fallback language was highlighted earlier this week at the Bond Buyer California Public Finance Conference by Priya Misra, managing director and global head of rates strategy at TD Securities, who said the immediate issue for the municipal bond market is dealing with its legacy book.

“There are muni bonds and a lot of Libor linked muni bonds that exist beyond the end of ‘21,” Misra said Monday. “In fact, most floating-rate muni bonds extend beyond ‘21 which means you have to look at your fallback now.”

Misra warned that the next milestone in the shift to the Secured Overnight Financing Rate is expected to be the announcement from the U.K.’s Financial Conduct Authority before the end of this year on the exact endpoint of its reference rate by declaring Libor as nonrepresentative.

That event will serve as the “death notice” for Libor to anyone who has been in denial about the expected phaseout at the end of 2021, she said.

“If that happens, I think it absolutely has an impact on the derivatives market, as well as the cash market,” Misra said. “Anybody with reliable exposure, that SEC announcement will mean something, maybe your hedge will be ineffective, maybe your bond or your swap will immediately move to SOFR. So it all depends on your fallback.”

Activity in interest-rate swaps linked to the SOFR surged this month to $84 billion as of Oct. 21, which is nearly triple the amount for the entire month of September, according to an analysis of CME Group figures by TD Securities.

Over the summer New York Federal Reserve President John Williams announced in a joint presentation with Bank of England Governor Andrew Bailey that the deadline for the phase-out of Libor at the end of 2021 will not be delayed despite the COVID-19 pandemic.

Johanna Som de Cerff, acting chief of Branch 5, IRS Office of Chief Counsel Financial Institutions, and Products Division, told an audience recently that the new IRS revenue procedure should “give comfort” to issuers worried about the tax consequences of “modifying your debt contracts, your swap, and other derivative contracts.”

Som de Cerff spoke during a webcast by the Government Finance Officers Association that was billed as a mini muni conference.

“What this guidance says is that, if you take that model language, and you put it in your contract, and it lists the kinds of contracts you can do this for, then it's not really an event for tax purposes,” she said.

The new language in the swap or bond issuance also will have to include an equivalent interest rate.

If that’s done, Som de Cerff said, “You don't have to worry that the IRS is going to treat that as a termination event or an exchange event or that somehow your swap can't be integrated. It's basically 'a nothing,' if you follow the narrow guidelines that are written into this revenue

The IRS also wants issuers and bond attorneys to submit comments prior to the end of 2021 about how the revenue procedure is working.

“You can inform the IRS as to what other things need to be addressed,” said Som de Cerff. “What are you going to need? What are you seeing? What problems are there?”

The comments will be used by the IRS the same way it uses comments on proposed regulations.

Jessica Giroux, director of governmental affairs for the National Association of Bond Lawyers, who moderated the panel discussion Som de Cerff spoke at, said the IRS decision to accept comments is “great.”

“Sometimes things don't go as smoothly as you want them to,” Giroux said. “And so this little allows some flexibility over at the IRS.”

The ISDA fallback language was announced Oct. 23 as the IBOR Fallbacks Supplement and IBOR Fallbacks Protocol.

ISDA said the supplement amends its standard definitions for interest rate derivatives to incorporate robust fallbacks for derivatives linked to certain IBORs, with the changes coming into effect on January 25, 2021. From that date, all new cleared and non-cleared derivatives that reference the definitions will include the fallbacks.

Additionally, ISDA said the protocol will enable market participants to incorporate the revisions into their legacy non-cleared derivatives trades with other counterparties that choose to adhere to the protocol. The protocol has been open for adherence since the Oct. 23 date of the announcement and also becomes effective on Jan. 25 almond with the supplement.

“With the fallbacks in place, derivatives market participants will be able to get on with transitioning their IBOR exposures with confidence that there is a robust back-up in case of need,” said ISDA Chief Executive Scott O’Malia.

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LIBOR Interest rate risk Muni tax exemption Washington DC TD Securities NABL GFOA