The Labor of LIBOR
Pacific Asset Management (PAM) is a Newport Beach, Calif.- based SEC registered investment adviser that specializes in institutional fixed income management, and features an investment professional team that carries multiple decades of experience managing an diverse suite of actively managed bond and floating rate loan portfolios, including as sub-advisor to the AdvisorShares Pacific Asset Enhanced Floating Rate ETF (FLRT).
Since mid-June, the three-month London Interbank Offered Rate (LIBOR)1 has increased by approximately 20 basis points.2 This is despite an unchanged federal funds rate in the United States and caution by the U.S. Federal Reserve (Fed) on future rate hikes. The rise in LIBOR has been driven in part by regulatory changes in U.S. money markets as the U.S. Securities and Exchange Commission adopts rules for floating-rate net asset value (NAV) for prime money-market funds.
It’s important to look at what this change in LIBOR is telling investors.
What This Change IS Telling Investors
The increase in LIBOR is a consequence of recent money market reforms. The upcoming floating-rate NAV requirement for prime money-market funds (this does not include government money-market funds) has resulted in large outflows (Chart 1). This has led to lower demand for financial securities that are referenced off of LIBOR, and thus higher rates in the ultra-short part of the yield curve.
Chart 1: Prime Money Market Flows Year to Date
Source: Strategas Research Partners, LLC. September 13, 2016.
In addition to the prime outflows we mention above, the uncertainty of future outflows may be magnifying the impact on LIBOR. Many investment managers are increasing liquidity and shortening the maturity of their debt, which limits the supply of short-term funding in the corporate financing market and increases borrowing costs.
While not explicitly tied to the federal funds target rate, the growing gap between this rate and LIBOR may act as a form of de facto tightening for many borrowers (notably small businesses and consumers). The rise in LIBOR may add to the cautious tone by the Fed.
As a result of this rise in LIBOR, investments in asset classes that benefit from rising short-term rates are seeing renewed interest and positive inflows (approximately $0.9 billion since mid-June3). Floating-rate loans, for example, may benefit if LIBOR continues to rise. In particular, if LIBOR were to rise above 1%, the coupons for this asset class may start to move higher once the floor (base interest rate) is exceeded.
What This Change IS NOT Telling Investors
While it may bring back memories of the 2008 financial crisis where we saw sharp rises in LIBOR, today’s move is not currently the result of increased interbank or financial stress.
The rise in LIBOR is currently not associated with concerns over bank credit quality as measures of credit sector risk have improved during this time. For example, banks generally have stronger balance sheets and more support from global central banks if financial stress were to occur. This view of risk can be seen in credit default swap spreads for banks, which have generally moved lower, reflecting a lower cost of insuring against defaults.
The rise in LIBOR is also not being driven by rising expectations of federal funds interest rate hikes. It may even be just the opposite, because expectations for hikes in 2016 continue to diminish. Based on the implied probability of fed futures, the market is pricing in just an 18% chance the U.S. Federal Reserve will raise rates at its September meeting, according to data compiled by Bloomberg. Additionally, the market sees just a 52% probability of a Fed rate hike before the end of 2016.4
Potential Investment Implications
We believe the recent run-up in LIBOR is more of an opportunity than a warning of problems to come. We do expect Fed officials to maintain focus on financial conditions as a whole as they consider a potential rate increase before year-end. However, should LIBOR continue to increase, we believe it could be a tailwind for certain asset classes such as floating-rate loans, which remain an option for investors searching for yield. The rise in LIBOR creates opportunities for investors to generate additional income as well as to add potential protection against rates rising in the future.
1 LIBOR is the benchmark interest rate that banks charge each other for loans. It serves as the benchmark reference rate for debt instruments, including government and corporate bonds, mortgages, student loans, and credit cards.
2 One basis point is equal to 0.01%.
3 Morningstar® 2016. Morningstar Bank Loan category flows for mutual funds and exchange-traded funds (ETFs) between June 15, 2016, and August 31, 2016.
4 Bloomberg, as of September 16, 2016.
All data is as of the date of this publication unless otherwise noted.