LIBOR-OIS: Time to Re-visit an Old Topic

Recently, there has been a widening in the spread relationship between LIBOR (London Interbank Offered Rate) and OIS (Overnight Interest Swap Rate). This prompts the question: Should this be of concern? Is it a “canary in the coal mine” signaling possible problems with overall bank credit, or is there some other viable explanation?

First, let us examine what these two rates represent and understand their historical relationship. LIBOR represents the daily average rate that banks charge one another in order to borrow cash overnight, as well as for longer periods. It is considered an unsecured loan reflecting the creditworthiness of the bank borrowers. The world’s largest lenders on the London Interbank Market create a daily average of their cost of funds, which is then reported as LIBOR.

The Overnight Interest Swap (OIS) rate represents the rate where high quality borrowers (commercial banks, corporations, central banks) can swap a variable rate payment for a fixed rate or vice versa. For example, a bank might want to swap a 3-month floating liability to a longer 5-year fixed rate liability to lock in their future cost in a rising rate environment. This rate would be called the OIS rate. In a swap, a notional dollar amount is agreed on between counterparties. However, the monthly payment settlements only represent the difference in the cash flows being exchanged (swapped). In this context, since no principal is at risk, “credit” risk is not the determining factor in calculating the OIS rate. So, the OIS rate will be below LIBOR, which has a credit worthiness component to it. In the recent period, as both rates have risen, it is LIBOR that has moved considerably faster, causing the spread widening. Why is this significant? The spread is a proxy for how expensive it will be for banks to borrow money now and in the future (represented as LIBOR) when compared to a near “risk free” rate paid by high quality swappers in the OIS market.

Historically, these two rates move somewhat in lockstep and typically trade less than 20 basis points apart. This is in part due to the perception that the world’s largest lenders/borrowers in the Interbank market are safe and solvent. Two periods during the past 15 years temporarily changed that relationship. During the European Sovereign Debt crisis and the U.S. 2007-2009 financial crisis, the LIBOR-OIS spread blew out significantly to over 150 basis points. It is evident that during these two periods banks had greater difficulty with overnight and short-term funding and the decline in credit worthiness of borrowers was reflected in very high LIBOR rates. Is this the case now?

The short answer is NO in our view, but we believe there is a confluence of factors driving the current situation. First among them is the tax law change that allows for repatriation of corporate dollars from overseas to come back home. A portion of these large pools of overseas funds, which were invested in commercial paper, money market instruments, and short corporate debentures, are now being repatriated and are NO longer available to invest or lend. Rates, including LIBOR, have to rise in order to attract new money or at a minimum keep the money abroad a little longer. This is in fact what has happened, and we believe it is considered a more permanent structural change than a short term technical factor. Secondly, the Treasury has recently ramped up the T-Bill auction size rather dramatically. We believe this trend will continue for the rest of the year as well. While not considered a direct link to rising LIBOR, the crowding out of LIBOR-related instruments due to the large T-Bill increases does have the secondary effect of driving up rates across the board. Not only does it drive up costs for the Treasury, but also for all other short borrowers who rely on repurchase agreements and commercial paper. Finally, as the Fed unwinds quantitative easing and reduces its balance sheet, reserves will tighten and further put upward pressure on short financing rates. Markets are usually quick to respond, LIBOR being no exception, and the Fed recently added an additional 25 basis points to the Fed Funds rate. 

In general, banks are still relatively flush with cash and carry abundant if not excess reserves. Their balance sheets are generally in a better position than before the 2008 financial crisis and their creditworthiness seems solid. Thus, we believe the rise in LIBOR is more a result of other factors, technical or structural (tax reform), than an expressed concern that the banking industry is poised for a global negative credit event.

The LIBOR-OIS spread still merits watching, but understanding the drivers of spread widening at this juncture may help eliminate what in previous cycles were growing bank credit concerns. Currently, bank liquidity concerns are not the cause in our view.

 

Robert Fernald

Portfolio Manager

 

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.