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Fixed-Income Insights

Based on feedback from advisors and investors, here are more insights on the implications of the recent spike in the benchmark lending rate.

 

In Brief

  • The recent move higher in the three-month London Interbank Offered Rate (LIBOR) has generated many questions from advisors and investors. 
  • Here, we address queries about:

    —The role of LIBOR in U.S. lending

    —The causes, and effects, of the recent spike in the benchmark rate

    —The likelihood that LIBOR will remain at current levels

    —The potential impact on prime money funds (which primarily invest in corporate debt securities)

    —The potential response from banks

    —How a potential U.S. Federal Reserve rate hike might influence LIBOR

  • The key takeaway— Interest in the recent LIBOR move likely will remain heightened for some time to come, especially as the implementation of money market reform becomes effective on October 14.

 

Talk about hitting a nerve: Our August 11th Fixed-Income Insights, “What a LIBOR Move Could Mean for Investors,” provoked a great deal of discussion among advisors and investors. Indeed, the sharp increase in the three-month London Interbank Offered Rate (LIBOR) addressed in the column has raised a number of important issues, ranging from concern about the higher cost of securities-based lending to the potentially beneficial impact on coupons of adjustable-rate bank loans in floating rate funds (a subject explored in depth in the August 29th Market View). 

To promote a better understanding of this unfolding development, we tackle below some of the most common questions we have received surrounding the unexpected jump in LIBOR. 

Why are U.S. loans, mortgages, and securities-based financing tied to a rate set in London?
LIBOR is the primary benchmark for short-term interest rates around the world. It is an index that measures the cost of funds to large global banks operating in London. Its daily transparent determination (recent manipulation cases aside) promoted global acceptance that has evolved into convention as a benchmark reference rate. According to the Intercontinental Exchange (ICE), LIBOR is referenced by US$350 trillion of outstanding business in different maturities. LIBOR is calculated for seven different maturities in five currencies. Three-month (90-day) U.S. dollar LIBOR is the most commonly used benchmark. 

Tell me again, why did the 90-day LIBOR jump when other short-term rates did not move?
Typically, if there are concerns about bank creditworthiness, bank financing, including LIBOR, will adjust higher in yield. Investors may be reluctant to lend to banks. That reduction in demand causes rates on financial commercial paper and bank deposits to move higher and the rate at which banks can borrow from each other, LIBOR, also rises.

The current rise appears unrelated to bank credit, but it is a function of reduced demand. U.S. money market reform, which takes effect October 14, allows net asset value (NAV) to remain at 1.0 (US$1) for U.S. government money market funds, but to float for U.S. prime money market funds—those that can invest in securities other than government obligations. Investor preference for the certainty of a US$1 NAV has caused many prime funds to change to government funds. In addition, the remaining prime funds have significantly reduced the average maturity of their investments to reduce NAV volatility.  Deutsche Bank, for example, reports that, as of mid-August, weighted average maturity for large institutional prime funds had dropped, to a record low of 12.7 days, from more than 30 days earlier this year.

The elimination of prime fund assets—as they move to government funds combined with the substantial reduction in maturities of investments purchased by the remaining prime funds—has reduced demand for bank financing beyond 30 days. Banks have turned to the interbank lending market, and LIBOR, notably the benchmark 90-day LIBOR, has moved higher. Essentially, money market reform likely will cause trillions of dollars in loans based on LIBOR to adjust to higher yields.

Is this jump permanent?
No one can project how long LIBOR will remain at higher levels, but the supply/demand factors clearly have changed. The elimination of several hundred billion dollars of prime money market funds in just the past few months, as they change to government money market funds and the reduction in average maturity of the remaining prime funds, substantially reduced demand for financial commercial paper and deposits with maturities beyond 30 days, forcing banks to bid up the yield on LIBOR. Without the emergence of a new group of substantial buyers, the new, wider yield relationship of 90-day LIBOR to 90-day U.S. Treasury bills and fed funds is likely to continue.

Won’t other investors substitute for prime money market funds if rates become more attractive?
Managers of corporate cash accounts are natural investors for attractively priced short-term bank financing. However, as active participants in money market investments, their continuous presence has failed to fill the void left by prime money market funds. The yield on short-term financial commercial paper and 90-day LIBOR has marched steadily higher (as October 14 approaches), despite their ongoing investment.

Other short-term investors likely will emerge to cap the yield relative to other investments. The launch of ultra-short-duration funds by investment managers may provide incremental demand for short-term investments, including bank financing, assuming these securities are attractively priced relative to other alternatives. Such developments may temper the yield rise of bank financing and 90-day LIBOR, but the growth of such assets would have to be dramatic to substitute for the demand lost through the attrition and changing investment patterns of prime money market funds. It is difficult to see an increase in demand capable of fully reversing the current yield premium created by money market reform.

Can banks change their financing structure to reduce pressure on 90-day LIBOR?
It seems unlikely that substantial changes will be made. Any extension beyond 90 days will increase costs. Banks may be able to raise some additional funds with shorter maturities, but the attrition of prime funds reduces demand for these maturities as well. In addition, the administrative costs and rollover uncertainties of sub-30-day financing reduce the appeal of the strategy as an effective substitute for 90-day LIBOR.

Instead of U.S. dollar LIBOR to finance dollar obligations, banks could access yen- or euro-denominated LIBOR and hedge back to U.S. dollars, but the costs after hedging currently are about 1.2%, compared to 0.83% for 90-day U.S. dollar LIBOR, according to Credit Suisse.

If the Fed raises rates in September or December, will 90-day LIBOR move higher as well?
A rate hike by the U.S. Federal Reserve (Fed) will be the rising tide that lifts all short-term yields. When the Fed raised rates in December 2015, 90-day Treasury bills, 90-day financial commercial paper, and 90-day LIBOR all adjusted about 25 basis points (bps) higher. Now that 90-day financial commercial paper and 90-day LIBOR trade at a wider yield premium to fed funds and 90-day Treasury bills, a Fed rate hike will likely raise most short-term investments by a similar amount. Investors will continue to demand the new yield premium, recently about 50 bps, for 90-day financial commercial paper relative to bills and fed funds. As fed funds and Treasury bills rise in yield, expect a similar movement from 90-day financial commercial paper and 90-day LIBOR.

Clearly, interest in the recent LIBOR move likely will remain heightened for months to come. We welcome any additional questions on the topic, and encourage you to contact your Lord Abbett representative or drop us an e-mail at clientsservices@lordabbett.com.

 

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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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