How to Invest in a Rising Rate Environment (Morningstar)

Libor Rising to the Occasion

By Emory Zink | 02-02-17 | 06:00 AM | Email Article

This  article appears in the February 2017 issue of Morningstar FundInvestor.  

The three-month London Interbank Offer Rate (Libor) surpassed 1 percentage point in early January 2017, a first since May 2009 for the widely referenced interest benchmark. The rate is derived by polling roughly 20 or so global banks on a daily basis for quotes of what they would charge other banks to borrow money for three months, dropping the outliers, and calculating an average. The result is used as a base rate for trillions of dollars in financial transactions and provides insight into liquidity and lending risk in the fixed-income markets. When Libor is higher, borrowing is more expensive, and when it is lower, funding is cheaper to access.

The 1% level may look modest, particularly given that Libor touched 5.7% in 2007, but relative to the rate’s post-financial crisis fate—it sat beneath 0.6% from June 2009 until nearly the end of 2015—its more recent ascent was notable. In 2016, it inched upwards, gaining momentum in the second half of the year as money market regulatory reforms hit full stride. The latter spurred many large investors to move assets out of prime money market funds with significant credit exposure into money markets composed of mostly government securities. Redemptions among prime money market funds trimmed demand for commercial paper and certificates of deposit, which in turn raised borrowing costs, and thus Libor’s levels. In fact, many ultrashort bond funds benefited from this structural adjustment, stepping in to snap up higher-yielding instruments at attractive prices leading up to and after the formal Oct. 14, 2016, date that money market reforms kicked in. The flexible  PIMCO Short-Term (PTSHX) and more buttoned-up  Fidelity Conservative Income Bond(FCONX) are two of our favored active ultrashort bond funds that have benefited from these market dislocations.

Bank loan investors have also benefited from the rise in three-month Libor. Minimum payouts for loans—typically referred to as floors—became ubiquitous after the rate plummeted during the financial crisis, and most floors stipulated that loans would continue to pay at least 1% plus a designated spread, even if Libor were to remain below that level. When three-month Libor rises and exceeds those 1% floors, though, as it did in early 2017, and loans began hitting their 90-day resets (typically) their coupons began floating higher to levels of Libor plus that additional yield premium built into each loan. Essentially, as Libor moved higher, floating-rate loans and notes based on that rate began to look more attractive.

The real question now is whether Libor will continue its climb. The U.S. Federal Reserve has hinted that it will likely gradually hike its own federal-funds rate in the coming months and years—Libor typically tracks that level closely during normal market conditions—which implies a trend of higher borrowing costs, if not necessarily a steep one. With prime money markets shrinking, ultrashort bond funds should likely continue to benefit by answering a healthy supply of commercial paper with selective demand, but there is no guarantee that supply won’t stagnate if borrowers seek less-costly forms of financing.

Perhaps even more important, though, is the impact that a rising Libor will have across an even broader expanse of financial markets given that most derivative transaction prices are linked to that rate, as well. It may seem like an obscure financial industry tool, but Libor is ultimately one of the most important rates affecting the entire global financial system.

Emory Zink is an analyst covering fixed-income strategies on Morningstar’s manager research team.