This month’s sharp rise in interest rates highlights the attractiveness of investing in shorter term bonds. Longer term, fixed-rate bonds generally decline in price when rates climb, while short-duration bonds are much less sensitive. Many “low duration” issues simply have shorter dated final maturities, while others have coupons which frequently adjust, or “float”, based upon an interest rate benchmark. The floating rate feature makes their market prices more stable by effectively replicating the process of continually rolling over short-term debt.

The most common benchmark used to adjust floating rate coupons is the London Interbank Offered Rate, commonly known as Libor. In fact, Libor-based obligations represent a massive financial market comprising over $200 trillion of securities, including derivatives. However, Libor pricing is based only upon a theoretical interest rate, arbitrarily determined by a handful of banks which may have a vested interest in the outcome.

Libor is computed using the average from a daily survey of about 20 banks which makes it more of a theoretical than a market-determined benchmark. Each day, these London-based banks are required to submit the rate of interest they would require in order to lend money to each other without collateral. In reality, only about $500 million of real-world transactions are used to set Libor each day, or less than 0.5 per cent of the total amount impacted by the benchmark.

For more than 30 years, Libor has provided a relatively convenient way to price myriad securities ranging from complex financial instruments to mortgages and student loans.

But the Libor pricing scandal of 2012 highlighted the challenges of using such an arbitrary benchmark. The highly publicised litigation culminated in large banks paying hundreds of millions of dollars in fines to governments around the world. Barclays Bank of London was fined $200 million in for its role in Libor rigging, but other banks in the US and Canada were also penalised.

At a recent conference in Miami, I had the opportunity to hear from a panel of experts who are actively working to replace Libor with a more objective rate.

To address the limitations of Libor, the Federal Reserve has set up the Alternative Reference Rates Committee (ARRC).

This has resulted in the introduction of the Secured Overnight Financing Rate (SOFR). SOFR is computed using spot rates in heavily traded securities and therefore is designed to be a more market-determined rate confirmed by large transaction volumes.

With so many existing Libor-based securities currently being traded, the ARRC acknowledges that broad-based acceptance of SOFR will require an extended adoption period.

For this reason, the committee has set 2021 as the target replacement date, allowing up to three years for conversion. The ARCC is also working on standard “fall-back” language to be added to securities’ prospectuses which would trigger a reversion to a SOFR derivative should this become necessary.

The Fed is keen on SOFR due to its greater stability. According to the Federal Reserve’s website, SOFR “is a broad measure of the cost of borrowing cash overnight collateralised by Treasury securities.”

And “SOFR includes all trades in the Broad General Collateral Rate plus bilateral Treasury repurchase agreement (repo) transactions cleared through the Delivery-versus-Payment (DVP) service offered by the Fixed Income Clearing Corporation (FICC)”.

The benchmark is a volume-weighted measure and the New York Fed claims about $800 billion in overnight transactions would be used to determine the rate.

In preparing for the new benchmark, the ARCC has laid out a detailed plan with some tactical moves already in progress. The world’s largest futures exchange, the CME Group, launched a SOFR futures contract in April of this year. As of last month, the Chicago exchange had already seen a cumulative trading volume of $711 billion, or 278,000 contracts, according to a recent article in the Financial Times. An actively traded, liquid futures market is essential for hedging purposes in buying and creating securities.

Last month, Wells Fargo issued the first non-government SOFR-linked bond making for a total of nine securities in the market now.

New issuance is expected to gradually increase over time. Metlife and Credit Suisse have also issued SOFR-linked securities, but these are not actively traded.

Trading SOFR notes may cause initial challenges for fixed-income portfolio managers, at least until the trend gains great popularity among institutional investors.

At the same time, Libor is expected to become a less dependable benchmark if some banks who are presently submitting Libor quotes begin to drop out of the survey as will be permitted over time.

Given the large volume of existing Libor-based instruments already in the market combined with the benchmark’s widespread historical acceptance, conversion will likely be a long and drawn-out process. However, financial-services professionals are wise to stay informed, however, as regulators are likely to continue their pressure on the industry.

With interest rates continuing their steady march upwards, floating rate securities are an excellent tool for preserving principal. Staying ahead of the curve on benchmark adjustments will be an important key to achieving strong relative investment performance.

• Bryan Dooley, CFA, is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 292-5000 for further information

• This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority