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Question of the Week - August 15, 2016

Question of the Week - August 15, 2016

Guest Post - Monday, August 15, 2016

What has caused LIBOR to move up so sharply?

As a refresher, LIBOR stands for the London Interbank Offered Rate, which is a benchmark rate for very short-term and variable rate corporate and other loans—including such things as some U.S. mortgages. These short corporate loans are often referred to as commercial paper. Because of their short maturities and decent rates (compared to government securities, because of their embedded credit spreads) they've been popular for decades as core holdings for money market funds, where principal stability, yield, liquidity and a short maturity are key characteristics. For lenders, mostly banks and other financial/industrial firms, these offer a convenient way to manage day-to-day cash flow needs in a cost-effective manner without having to disrupt other balance sheet assets. Because of the high quality of issuers and appetite of investors to earn a higher yield over bank deposits, there had been a healthy balance that created a robust market for such paper—with money funds leading the way.

As many of us are familiar, money market fund net asset values have been pegged at a set $1.00 a share for many years. The underlying securities in a money market portfolio, of course, did change in value behind the scenes and actual NAV's would fluctuate a few cents from $0.99 to $1.01, for example; but accounting rules allowed these to be set to their book value, keeping NAVs stable. While these funds weren't guaranteed in the same vein as FDIC-insured bank deposits, the financial industry as a whole have considered such funds to be quite safe and money market fund providers considered 'breaking the buck' to be a cardinal sin of money fund management. Funds would avoid doing this at all costs, due to the potential reputational impact on the offending firm.

Enter the financial crisis of 2008. Unfortunately, a handful of money market funds got carried away seeking higher yields through less liquid paper, and as occurred in the broader bond market, funds needed to sell whatever they had on hand, including higher-quality liquid securities, in order to meet redemption needs. This caused a few funds to take on higher losses than expected, forcing their prices to fall below a dollar. Accordingly, new rules were hashed out over the last several years to prevent such an event from happening again, and, at the very least, segment out risks in money market portfolios to various product tiers. What does that mean? Basically, as of October, it will be the addition of 'redemption gates' (periods where investors can't get money out or will have to pay a redemption fee of a few percent to do so) and 'floating NAVs' (which, as it sounds, means $1 doesn't mean $1 anymore, as NAV's will fluctuate like other funds). There are some exceptions, such as retail money market funds investing in government debt—these will retain all of their prior safe qualities—but 'prime' (commercial paper) funds will be subject to greater restrictions. As an aside, we'll likely have more on the money market changes as we get closer to October and regulations are implemented.

This has created a bit of a vacuum for prime money market funds, as well as lenders. Since prime funds offered higher yields from commercial paper, as opposed to government funds, they've always been popular and still house nearly a trillion dollars in investor assets. Now, due to upcoming regulations and in an effort to improve investor safety and liquidity, major fund groups have started consolidating money market funds, and reducing the number that could be subject to restrictions. (In anticipation of this, many 'default' sweep options for brokerage firms and fund companies have been generally converted to the government/stable-NAV variety to prevent any surprises for short-term investors.) This closes a window for commercial paper buyers, which has led to LIBOR creeping up, as other buyers have to be incented to now buy this paper. Supply of paper has also fallen somewhat, as banks have been less aggressive in leveraging their balance sheets as yield spreads are less attractive, and non-financial firms have also taken on less debt, but this market is quite large and isn't likely to go away any time soon.

What else does this influence? Other corporate loans (like floating rate bank loans), construction and other real estate loans, as well as certain consumer loans (including home mortgage, credit card, auto and student loans) are pegged to LIBOR. While 3-mo. LIBOR has only moved higher by 15-20 basis points in the last several months, with rates being so low on an absolute level, it may have surprised some investors who watch interest rates closely.

FRED graph

Read our Weekly Review for August 15, 2016.

Read the previous Question of the Week for July 11, 2016.

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