FIXED-INCOME INSIGHTS What a LIBOR Move Could Mean for Investors August 11, 2016 Zane E. Brown Partner, Fixed Income Strategist 9343 Views Pending changes to U.S. money market funds appear to be pushing this globally used interest-rate benchmark higher. One potential beneficiary: bank loans. In Brief The recent jump in the three-month London Interbank Of f ered Rate (LIBOR) appears to have been triggered by the pending implementation of new regulations f or U.S. money market f unds. Why? As prime money market funds (i.e., those that invest in corporate bonds) shift their holdings to government funds, demand for short-term bank debt has evaporated. This reflects reduced demand for bank financing from money market funds, forcing banks to bid higher in the LIBOR market. Rates on LIBOR-based bank loans and floating-rate mortgages likely will now adjust upward to reflect a LIBOR benchmark that has moved 0.25% higher, while the rates on U.S. fed funds and three-month Treasury bills remain unchanged. The potential consequences of a sustained upward adjustment in LIBOR include a delay in the next U.S. Federal Reserve (Fed) rate hike and increased consumer and business-f inancing costs. The key takeaway The increase in this global interest-rate benchmark could also have a salutary effect for investors, enhancing the yield appeal of LIBOR-based investments such as bank loans. Who would have thought that efforts to reform the money market could instead result in the equivalent of a 25 basis-point tightening by the U.S. Federal Reserve (Fed) without the U.S. central bank lif ting a f inger? The recent jump in the three-month London Interbank Of f ered Rate (LIBOR), which appears to have been triggered by the pending implementation of new regulations for U.S. money market funds, carries important economic consequences that could affect bank prof itability, corporate borrowing costs, U.S. f loating-rate mortgages, and investment opportunities in general. LIBOR is the rate banks charge each other f or eurodollars in the London interbank market, not dissimilar to the fed funds rate that U.S. banks charge each other for overnight U.S. deposits. Eurodollars are U.S. dollar-denominated deposits at f oreign banks. The bank loans in which many 1
U.S. floating-rate mutual funds invest are generally based on LIBOR. The rise in LIBOR could act similarly to a monetary tightening by the Fed, restricting economic activity just when the U.S. central bank has chosen to delay raising rates. Whether this rise in LIBOR is temporary or long-lasting will determine its impact on monetary policy, economic activity, and the investment perf ormance of some securities. LIBOR Spike Throughout 2015, three-month LIBOR was about 0.25% higher than the yield on three-month U.S. Treasury bills. By early August 2016, however, the premium jumped, to 0.50%. Historically, such a move would suggest rising bank credit concerns, but prices on bank-credit def ault swaps remain largely unaffected, according to Bloomberg data, suggesting a different explanation. This is where pending U.S. money market reform appears to be having an impact. Effective October 14, 2016, prime institutional money market f unds will be required to f loat their net asset values, rather than f ixing them at $1.00 per share. At the same time, all non-government money market funds will be able to impose redemption fees, or liquidity gates, if fund liquidity falls below def ined limits. Solutions to these new regulations directly af f ect bank f inancing, which in turn f orce LIBOR higher. Here s how this phenomenon appears to be playing out. As prime money market f unds (i.e., those that invest in corporate bonds) shif t their holdings to government f unds, demand f or short-term bank debt has evaporated. For instance, the $115 billion Fidelity Cash Reserves Fund, earlier this year, changed its mandate to include only government-related securities. In addition, Société Generale reported in late July that just since the start of June, $135 billion of assets has exited prime f unds, while a like amount has entered government money market f unds. Such shif ts reduce demand for bank financing from money market funds, forcing banks to bid higher in the LIBOR market. Barron s recently reported that up to an estimated $1 trillion is expected to move f rom prime to government-only f unds, implying even greater impact on LIBOR rates as that shif t gains momentum with the October 14 implementation date looming. Economic Consequences If international banks have access to any kind of U.S. dollar f inancing that could substitute f or their reliance on money market f unds, the spike in LIBOR yields could be temporary. However, no such alternative seems readily at hand. One option may be to borrow money outside the United States and then convert the money back to U.S. dollars. A July 26th Financial Times article quoted total costs of 1.2% f or such f unding, substantially higher than the 0.74% three-month LIBOR at the time. Another option may be to borrow f rom the European Central Bank against dollar swap lines established by the Fed. However, this carries some reputational risk f or those institutions willing to take the plunge, because such lines typically are intended f or extenuating circumstances (read: f inancial distress), not ongoing f inancing. Without a dollar-f unding alternative, the recent spike in LIBOR may ref lect a new equilibrium, where three-month LIBOR continues to trade at a 0.50% premium to three-month Treasury bills. If no new source of f unding emerges, this new equilibrium, in many respects, represents a 0.25% tightening in interest rates, without the Fed s participation. This has signif icant implications f or credit markets. Rates on LIBOR-based bank loans and f loating-rate mortgages likely will now adjust upward in order to ref lect a LIBOR benchmark that has moved 0.25% higher, while the rates f or f ed f unds and three-month Treasury bills remain unchanged. Student loans and credit cards, f or example, which of ten are tied to LIBOR, also will adjust higher. For loans with a one-year LIBOR-adjustment benchmark, the relative impact of a swif t upward adjustment in rates will be even greater than an increase in three-month LIBOR. Investment Implications The mirror image of a LIBOR increase s adverse impact on borrowers will be its benef icial ef f ect 2
f or lenders and investors. Certainly, some adjustable mortgage-related securities will benef it via higher rates. Another important benef it will be realized by f loating-rate f unds. The bank loans they invest in could see upward yield adjustments and soon. Recent bank-loan investments have offered an interest-rate floor of LIBOR plus 0.75%, compared to a standard of LIBOR plus 1.00% over the past f ew years. This new f eature, combined with the recent spike in three-month LIBOR, to 0.77%, suggests the interest rate on such debt is poised to adjust higher f ar sooner than many investors expect. That s especially important, because LIBOR plus 0.75% loans represent 24% of LIBOR-based loans outstanding. In f act, by September 30, when some such loans may reset, investors could see some modest adjustment higher in the coupon, ref lecting LIBOR above the interest-rate f loor. Any subsequent hike in short-term rates by the Fed likely will push the rate on LIBOR plus 0.75% bank loans that much higher, assuming LIBOR maintains its current, higher spread relationship to short-term Treasuries. For bank loans with a rate floor of LIBOR plus 1.00%, a rate adjustment will require some additional movement higher in short-term rates, but with LIBOR at today s yield premium, the f loor could be breached with f ed f unds at 0.50 0.75%, long bef ore many investors expectation of a 1.00% fed funds rate. Summing Up The recent spike in three-month LIBOR seems an appropriate response to a major reduction in money market demand f or short-term international bank f inancing. Without a f inancing alternative, bank financing costs and LIBOR could find a new equilibrium at a higher absolute rate, and a higher spread relative to U.S. Treasuries. The potential consequences of such an adjustment to perhaps the world s most widely used f inancing benchmark include a delay in the next Fed rate hike, increasing consumer and businessf inancing costs, and enhancing the yield appeal of certain short-term investments as well as LIBOR-based investments, such as bank loans. Investors, borrowers, and government of f icials will be watching closely as the money market ref orm measures finally take effect. The degree to which LIBOR is ultimately affected will be crucial; according to a recent Bloomberg article, the U.K. Treasury, at one point, estimated that LIBOR rates were the basis f or valuing $300 trillion of global securities. Clearly, ref orm-minded U.S. officials did not set out to cause swift and substantial changes to a globally used interest-rate benchmark when they f ormulated the new regulations. Alas, policymakers have yet to f ind a way to rescind the rule of unintended consequences. A Note about Risk: The value of investments in f ixed-income securities will change as interest rates f luctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities f all, and when interest rates f all, prices generally rise. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of def ault in the timely payment of interest and principal. Moreover, the specif ic collateral used to secure a loan may decline in value or become illiquid, which would adversely af f ect the loan s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the ef f ect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee f uture results. A money market fund is an investment whose objective is to earn interest f or shareholders while maintaining a net asset value (NAV) of $1 per share. A money market f und s portf olio is comprised of short-term, or less than one year, 3
securities representing high-quality, liquid debt and monetary instruments. Investors can purchase shares of money market f unds through mutual f unds, brokerage f irms and banks. Money market f unds that primarily invest in corporate debt securities are ref erred to as prime funds. An investment in a money market f und is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market f und seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a f und. Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. There is no guarantee that markets will perf orm in a similar manner under similar conditions in the f uture. The fed funds rate is the interest rate at which a depository institution lends immediately available f unds (balances at the Federal Reserve) to another depository institution overnight. LIBOR is an interest rate at which banks can borrow f unds, in marketable size, f rom other banks in the London interbank market. The LIBOR is f ixed on a daily basis by the British Bankers' Association. The LIBOR is derived f rom a f iltered average of the world's most creditworthy banks' interbank deposit rates f or larger loans with maturities between overnight and one f ull year. The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision. Investors should carefully consider the investment objectives, risks, charges and expenses of the Lord Abbett Funds. This and other important information is contained in the fund's summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, you can click here or contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388. Read the prospectus carefully before you invest or send money. Not FDIC-Insured. May lose value. Not guaranteed by any bank. Copyright 2018 Lord, Abbett & Co. LLC. All rights reserved. Lord Abbett mutual funds are distributed by Lord Abbett Distributor LLC. For U.S. residents only. 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. 4
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