What Rising Libor Means for You

Gaining an understanding of finance can be difficult given the number of complex details and caveats that make up the markets. For this reason, some of the most important concepts often go overlooked or misunderstood, one of those being Libor (London inter-bank offered rate). Libor, by definition, is the standard market interest rate that banks and financial institutions charge each other for short-term loans.

It is considered to be the most important benchmark in in finance, upon which trillion of dollars rest.

Oversight of Libor was recently passed to the Intercontinental Exchange from the British Bankers Association, after allegations of rate manipulation came to light.

Every morning, ICE asks a group of 11 to 17 leading banks to estimate an interest rate they would be willing to receive from other financial institutions to extend a short-term loan. In total, banks submit 35 rates across five currencies (USD, EUR, GPD, JPY, CHF) and seven different maturity dates, ranging from overnight to a year.

Each estimate is ranked in descending order and then arithmetically averaged to determine a final rate. The final calculations exclude the top and bottom quartiles of submissions to prevent outliers from skewing the results.

Considering banks determine rates, experts often use Libor as a measure of confidence within the financial sector and the Federal Reserve. The term also resonates with individual investors and consumers as it impacts the interest rates on mortgages, business loans, and student debt.

In recent months, the 3-month dollar Libor rate has risen to its highest level since the 2008 Financial Crisis.  During the recession, rates spiked over concerns that short-term lending to distressed financial institutions would backfire. The latest move, however, has less to do with financial institutions and more to do with new regulatory changes on U.S. money market funds that went into effect in mid-October.

The reform requires funds to move from a $1 fixed net asset value (NAV) to a floating NAV while also implementing liquidity fees and redemption gates. These measures have been put in place to safeguard against a repeat of the crisis, which was met with massive outflows and one prominent money market fund “breaking the buck,” meaning NAV dropped below the $1 threshold.

 

 

The regulatory changes have already caused a major shift in money market fund assets (MMF) away from prime funds, traditionally commercial paper and certificates of deposit, and into government funds. Until last week, institutional prime fund assets were down nearly $900 billion from August 2015, where government only fund assets increased roughly $825 billion.

This makes it more problematic for investors to redeem holdings from prime funds and is significantly denting demand for commercial paper and certificates of deposits. As a result, banks have been left searching for new sources of funding, putting upward pressure on overall borrowing costs, otherwise known as Libor.

 

 

The effects of higher borrowing costs trickle down to individual investors and borrowers in the form of costlier loan payments. Borrowers can avoid any additional costs by refinancing existing loans to a fixed rate or simply saving more. Higher interest rates make it more expensive to borrow, but also incentivizes saving in the short term.

Libor’s recent move higher also impacts the broader stock market, but in a less formal manner. It indirectly drives shares lower by making it more difficult for companies to facilitate growth initiatives through borrowing funds. This leads to stunted earnings potential and weak fundamentals which are often a precursor to declining stock prices.

Some experts recommend hedging against this risk with leverage loan funds or Libor based floating rate funds such as PowerShares Senior Portfolio ETF (BLKN). Other options include REITs, which have a large percentage of their assets in variable rate loans, that benefit with increasing Libor rates. Although higher rates should theoretically drag down the market, many other factors come into play when determining share prices.

An overhaul in the money market industry followed by an increase in Libor rates has evoked shades of the 2008 global financial crisis. But the recent jump is not a signal of credit stress in the financial sector, rather a changing regulatory environment. The new regulations imposed by the SEC have subsequently put pressure on prime money market funds and financial institutions, but also individual borrowers with floating rate debt. That said, the situation brewing in the markets today is a sign of future investment opportunities as opposed to upcoming misfortunes.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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