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Fixed-Income Insights

Certain technical factors, as opposed to financial risks, may be leading to the divergence between Libor and OIS.

 

In Brief:

  • Most short-term market rates are moving higher, as the U.S. Federal Reserve (Fed) has made clear its intention to increase the fed funds rate, given a strong U.S. economy.
  • But the widening spread between the dollar London Interbank Offered Rate (Libor) and the overnight indexed swap rate has some investors concerned about increased financial risk.
  • We believe that short-term technical factors, chiefly the increased issuance of U.S. Treasury bills in the 2018 first quarter, are at play here.
  • In this environment, floating-rate loans have provided an attractive yield pick-up over short-term Treasury bills, with little interest-rate exposure.

 

Most short-term market rates are moving higher, as the U.S. Federal Reserve (Fed) has made clear that it will continue to increase the fed funds rate, given its expectation of a strengthening U.S. economy.  Clearly, an improving economy is good news for investors.

 

Source: Bloomberg. Libor is the three-month London interbank offered rate. Commercial paper is the average yield in the 30-Day A2/P2 Nonfinancial Commercial Paper Interest Rate Index. IG FRN is the average coupon in the Bloomberg Barclays Investment Grade Floating Rate Note Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

But there has been some movement as well in a rather arcane part of the short-term interest rate market—the Libor–OIS spread—and this has prompted questions from some investors:  What exactly is the Libor–OIS spread? And, is a widening of that spread necessarily a sign of trouble for the banking system?

Defining the Question
The London interbank offered rate (Libor) is a benchmark rate that some of the world’s leading banks charge each other for short-term, unsecured loans. The interest charges on many mortgages, credit cards, and other financial products are tied to Libor rates.

The overnight indexed swap (OIS) rate is calculated from swap agreements in which market participants exchange fixed- for floating-rate cash flows. Many swap rates are tied to the fed funds target rate, and thus are regarded as a gauge of market expectations for future fed funds rates.

The Libor–OIS spread is an indication of how expensive it is for banks to borrow relative to a risk-free rate, so a wider spread may be a signal of stress in the banking system.

Currently, as Chart 2 illustrates, the Libor–OIS spread has risen nearly 45 basis points (bps) over the past six months, and is approaching 60 bps, and that is the highest level since the financial crisis of 2008–09.   

 

Source: Bloomberg. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Is the Libor–OIS spread, therefore, sending a warning signal?  Is a widening spread necessarily an indicator of financial risk?  We don’t think so. There are some short-term technical factors that are at work here and that distinguish today’s spread widening from those of prior experience.

Short-Term Technical Factors
Chief among these factors is an increased supply of U.S. Treasury bills. Issuance of U.S. Treasury bills (and notes and bonds, for that matter) rose in the first quarter of 2018, according to the Fed, following February’s agreement by the U.S. Congress on further fiscal spending. With that crisis passed, the U.S. Treasury has been replenishing its cash balance, and that has meant a flood of debt sales, particularly of shorter-dated securities. That, in turn, has driven up borrowing costs not only for the United States government but also for other borrowers in the short-term market. In our opinion, therefore, the most likely cause of the rising Libor–OIS gap has been the increased supply of short-term Treasuries, not rising credit risk.  Equally important, T-bill issuance is expected to decline significantly in the second quarter, according to Barclays, which may reverse some of the recent widening.  

Another factor may be the U.S. tax reform passed by Congress in December 2017. The new law offers incentives for corporations to bring money back to the United States that they had previously kept overseas. This has reduced offshore cash at U.S. multinationals as a source of funding, forcing these companies to increase their borrowing in the short-term markets, leading to higher rates in the commercial paper (CP) market and widening the CP–Treasury bill spread.

And finally, looking at short-term lending in other currencies indicates that the Libor–OIS spread widening is specific to U.S. dollar borrowing and not a sign of broader financial market stress. According to Giulio Martini, Lord Abbett partner and director of strategic asset allocation, this is one of the reasons why Libor–OIS has spiked higher, while the spreads between OIS and both the Euro interbank offered rate and the Tokyo interbank offered rate have not. There is a shortage of U.S. dollar funding in the markets at the moment, while other currencies are in ample supply.

“The fact that central banks have not activated their dollar-swap facilities with the Fed in recent days shows that they view this as a transitory problem, not a systematic one,” Martini said. “And the fact that spreads for borrowing other currencies have narrowed strongly implies that rising counterparty risk isn’t an issue.  In other words, U.S. dollar-borrowing frictions are significant, but this is not due to deteriorating creditworthiness among borrowers, and thus shouldn’t translate into slower growth in the real economy.”  

Investment Implications
In brief, far from being an indicator of financial stress, we believe the widening Libor–OIS spread is due in large part to short-term technical factors. But signs of a stronger U.S. economy have led to expectations of continued Fed rate hikes, pushing many short-term rates higher. What are the implications for investors?

 

Source: Credit Suisse The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. 

 

Within the investment-grade sector, this has led to much higher rates on investment-grade floating-rate notes (FRNs) and short-term commercial paper. As illustrated in Chart 1, rates on FRNs and commercial paper increased by 43 and 68 basis points, respectively, in the first quarter. These instruments provide an attractive yield pick-up over cash or short-term Treasury bills, and have very little interest-rate exposure, which may make them a key component of ultra-short bond strategies.    

Higher yields also have been seen in floating-rate bank loans.  In recent years, the average coupon in the Credit Suisse Leveraged Loan Index has been range-bound, as rising Libor rates have been offset by issuers refinancing at lower spreads. Recently, however, coupons have moved higher (see Chart 3), increasing 40 bps so far this year (as of March 31, 2018).

A strong U.S. economy is a positive sign for bank loans and for credit fundamentals in general, suggesting defaults should remain low. The combination of higher coupons on bank loans in the context of a strong U.S. economy should create a good environment for bank loans going forward.

 

Past performance is not a reliable indicator or a guarantee of future results.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As interest rates rise, the prices of debt securities tend to fall. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. The principal risks associated with bank loans are credit quality, market liquidity, default risk and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default.

Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

There is no guarantee that the floating-rate loan market will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described above.

Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

Glossary

A basis point (bps) is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.

coupon is the annual interest rate paid on a bond, expressed as a percentage of the face value.

Fed funds are overnight borrowings between banks and other entities to maintain their bank reserves at the U.S. Federal Reserve (Fed). Banks keep reserves at Fed banks to meet their reserve requirements and to clear financial transactions.

The London interbank offered rate (Libor) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world.

The Overnight Indexed Swap (OIS) is a swap derived from the overnight rate, which is generally fixed by a central bank. The OIS allows Libor-based banks to borrow at a fixed rate of interest over the same period. In the United States, the spread is based on the Libor eurodollar rate and the Fed’s fed funds rate.

Treasuries are debt securities issued by the U.S. government and are secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The Bloomberg Barclays Investment Grade Floating Rate Note Index measures the performance of U.S.-denominated, investment-grade, floating-rate notes across corporate and government-related sectors.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged-loan market.

The A2/P2 Nonfinancial Commercial Paper Interest Rate Index is calculated daily by the U.S. Federal Reserve from data supplied by The Depository Trust & Clearing Corporation and is a statistical aggregation of numerous data reflecting many trades for different issuers in the commercial-paper market.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this article are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

About The Author

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The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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