The London Interbank Offered Rate (LIBOR) has risen significantly since the beginning of the year relative to other short-term rates—and what’s happening has a lot to do with U.S. tax reform and repatriation of corporate cash balances.
LIBOR is a widely used proxy for AA-rated credit risk and as a reference rate for a variety of financial instruments, including interest rates on credit cards, auto loans, student loans, business lines of credit, and certain corporate bonds, to name a few.
Year to date as of March 22, 2018, 3-month USD LIBOR has increased by 0.59% and is at 2.29%.
The spread between 3-month USD LIBOR and the 3-month U.S. Treasury bill rate—computed as 3-month USD LIBOR minus the 3-month U.S. Treasury bill rate—is one way to measure how much LIBOR is changing relative to other short-term rates. This spread is monitored by short-term investors as an indication of deteriorating credit market conditions.
This spread has spiked over the past few weeks, as the chart below illustrates, prompting concerns about the root cause of the increase.
The chart below puts the recent increase in the 3-Month LIBOR-Treasury bill spread into context.
What’s the Cause?
It’s not surprising that short-term interest rates are rising. Short-term interest rates have been rising since 2015 commensurate with perceived and actual interest rate hikes by the Federal Reserve (Fed). On March 21, the Federal Reserve (Fed) increased the target range for the federal funds rate for the first time this year, and the market anticipates two to three additional rate hikes in 2018.
We believe LIBOR has increased faster than other short-term rates over the past few weeks due to U.S. tax reform and repatriation of corporate cash balances. U.S. tax reform incentivized U.S. corporations to move offshore cash balances back to short-term domestic markets, and this phenomenon can be explained by U.S. dollar deposits leaving foreign banks and going to U.S. money markets and banks.
We have seen estimates indicating that U.S. corporations had more than $1 trillion of corporate cash held offshore that can be repatriated. The graphic below illustrates this explanation.
Is There Cause for Concern?
As mentioned, market participants monitor changes in the LIBOR-Treasury bill spread as an indication of deterioration in the credit markets. We do not believe the recent surge in this spread is indicative of deteriorating credit market conditions.
We do not believe the recent surge in this spread is indicative of deteriorating credit market conditions.
Rather, we believe the increase in the spread is attributable to technical factors: an increase in demand for one type of short-term instrument and a subsequent decrease in demand for another type of short-term instrument due to corporate repatriation of cash balances following U.S. tax reform.
What Are the Implications?
It is nearly impossible to quantify how changes in LIBOR affect the fixed income markets, because the rate is widely used as a reference rate for derivatives, mortgages, asset-backed securities, corporate bonds, and bank loans, to name a few.
Rather than trying to comment on the variety of ways these recent conditions affect the fixed income markets, we will focus on a very narrow segment of the market that we monitor for client portfolios.
The recent increase in LIBOR is beneficial to high-quality floating-rate instruments that use LIBOR to determine their coupon rates. We have been employing such instruments in our Low Duration strategy as a defensive maneuver to help protect principal during a period of rising short-term interest rates.
Unlike fixed-rate bonds, floating-rate bond prices change very little as interest rates change because the coupon terms are variable.
The coupon rates on these instruments are determined by adding a fixed spread to the prevailing level of either 1-month or 3-month USD LIBOR on the predetermined coupon reset dates. These instruments should benefit from having coupon rates that reset higher based on LIBOR, while maintaining relative stability of price.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with market interest rates, and income received from floating rate securities may decline when interest rates fall.
Kathy Lynch, CFA, is a portfolio manager on William Blair’s Fixed Income team.