Libor's Climb May Reveal Unique Opportunity

The last time Libor rates spiked was a period no one really wants to remember: the 2008 financial crisis. Back then, a soaring Libor—the interest rate banks charge each other for short-term loans—signaled concern that short-term lending to distressed financial institutions could backfire.

Now, Libor rates are up (recently above 1% for first time since 2009) for a much different reason—U.S. money market reform.

Regulatory changes stemming from the financial crisis that took effect in October set off a shift in money market fund assets (MMF) out of prime funds—traditionally invested in commercial paper and CDs—and into government funds. These developments have presented a unique opportunity for investors looking for short-duration assets.

What are money market funds and why are they being reformed?

Money market funds, comprising short-term, high-grade liquid debt, have historically offered slightly better returns than bank deposits but with the same level of security. That assumption of security was called into question in 2008, however, when shares of the Reserve Primary Fund, a well-known U.S. money market fund, "broke the buck" and dipped below $1 net asset value (NAV). Investors and regulators alike were spooked.

In response, the SEC developed new regulations designed to enhance transparency and stability in money market funds. The rules also establish three categories of funds—retail, government and institutional—and permit retail and government funds to continue utilizing a stable $1 NAV.

Why are Libor rates rising?

Institutional prime funds can invest in a wider variety of assets and are now required to publish "floating" NAVs based on the current value of the assets they hold. Leading into the October 14th deadline, investors fled en masse, with more than $1 trillion of assets under management (AUM) moved from prime to government funds.

As AUM flowed out of prime funds—and funds cut additional funding in anticipation of further outflows—commercial paper and CD rates moved meaningfully higher, dragging up Libor with them.

What are the opportunities for investors?

A unique opportunity has opened up for a certain kind of individual investor, says Daniel McCormick, a Managing Director with Morgan Stanley Wealth Management.  “If you're a larger investor who has been in the bank deposit program, or buying short-term T-bills to stay liquid, this is finally creating an opportunity for you to build your own portfolio if you have the right kind of capital," he says. “This dynamic certainly wouldn't be in place if these regulatory changes hadn't come into play."

Generally speaking, opportunities lie in short-term investment-grade corporates, high-yield corporates, and municipals, which have sharply higher yields compared to six months ago. For 6-to-12-month corporate paper, for example, McCormick estimates that investors could see at least a 1% gain on a money market yield.

“One percent may not sound exciting," he acknowledges, "but when you're comparing it to money market funds or bank deposit program and other alternatives, 1% is a significant yield pickup."

Are Libor rates going to climb higher?

Paul Servidio, an Executive Director with Morgan Stanley Wealth Management Fixed Income, says some were concerned that Libor rates would decline once the reforms were implemented, but that's been far from the case. “3 month Libor is at its highest level since 2009, and has continued to grind higher post reform," Servidio says.

What's more: It's possible rates will go even higher now that the Fed has gone ahead with its December rate hike. Servidio says Morgan Stanley is calling for two more rate hikes next year and three hikes in 2018, for a year-end 2018 target range of 1.75-2.00%.

“Historically, Fed Funds and Libor have been highly correlated.1 Even if the pace of hikes is slower than expected, we can still likely experience higher front end rates over the next 12-18 months.

So when is a good time to take action? Today, says McCormick. “Right now is a great time—before the market starts pricing in any potential hikes in 2017."

Morgan Stanley's Wealth Management Capital Markets group provides timely, actionable investment advice to clients by relying on a unique, fully integrated sales and research model. 

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