Exhibit 1: USD Libor has risen to its highest level since 2008
USD 3-month Libor rate monthly 2004–April 11, 2018
Why is US Libor rising?
We believe the increase in USD Libor is the result of a combination of different factors coming together all at the same time. US tax reform has precipitated a repatriation of overseas cash by US corporations. This ‘overseas cash’ had become a significant source of funding for global markets. With much of this money now returning to the US, non-US banks may have then had to pay more to attract USD funding, leading to an increase in Libor. Related to this repatriation of cash, US corporations themselves are likely to be focused on using some of this cash for M&A and capital expenditure, thus reducing the demand for commercial paper and other money market instruments. This has coincided with increased US Treasury Bill issuance, thus putting pressure on money market rates by ‘crowding out’ commercial paper markets. These higher rates in the US commercial paper markets ultimately feed through into increases in the Libor rate.
A sharp increase in issuance of bills by the US Treasury, consequent market indigestion and increases in T-bill yields followed the raising of the US debt ceiling in early February this year and the increasing need to fund a rising US budget deficit. Why is this important? The US T-bill rate acts as a reference rate for unsecured borrowing rates such as Libor.
Libor has also risen during previous periods of Fed rate hikes, however recently the magnitude of the increase in US Libor has been greater than that of the Fed funds rate. Short-term corporate bond yields have also risen, alongside the increase in Treasury yields. In effect, Libor’s increase represents an additional tightening of financial conditions over and above the Fed’s path of interest rate increases. We expect Libor rates to normalize as these various factors ‘normalize’ to more typical market conditions.
What is the impact on floating rate bonds?
Floating rate bonds have two components—one component is based on a floating reference rate, such as Libor, and a second component being a spread, which is based on the bond issuer’s credit quality. Depending on the individual bond terms, the coupon is adjusted periodically, typically quarterly, so any increase in interest rates is soon reflected in the yields of the bonds. Therefore cash flow will increase in a rising rate environment. Because coupon rates mirror the market interest rate, floating rate bonds have very low price sensitivity to changes in interest rates.
If an investor borrows money based on Libor plus a spread and then invests in a floating rate bond fund there is then a natural hedge for the cost of borrowing. As interest rates and Libor increase, the cost of the financing increases. However, the coupons on the floating rate bonds will also increase, subject to the lagged effect of re-sets in the bond documentation (typically a 3-month re-set). For comparison purposes an investor who uses leverage to invest in a fixed coupon high yield bond fund has no such accompanying increase in coupon income to accompany their increased cost of borrowing as Libor increases. If anything investors might face a gradual reduction in the market value of their fixed coupon high yield portfolio due to interest rate increases.
Exhibit 2: What is expected from floating rate notes?
Coupon increases with the raise in Libor