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What do rising Libor rates mean for investors?

26 October 2016 in Investing Insights

Key Takeaways

  • Libor is a benchmark for more than $300 trillion worth of investments worldwide, one of the most widely used benchmarks in finance.
  • Libor rates have risen to their highest levels in over seven years since the end of the financial crisis.
  • Analysts believe the anticipation of SEC regulatory changes on U.S. money market funds (MMFs), which went into effect on October 14 have been pushing Libor rates up.

Interest rates have been a hot topic this year. Libor in particular has drawn a lot of attention recently. Not quite sure what Libor is? We’ll review the basics of Libor below, discuss why it has been rising and how this impacts investors.

What is Libor?

Libor stands for London inter-bank lending rate. It’s an important interest rate to monitor because it’s one of the most widely used benchmarks in finance. More than $300 trillion worth of investments worldwide use Libor as a benchmark.[1] Examples of security types that often reference Libor include government bonds, corporate bonds, mortgages, student loans and credit cards.

Libor is administered by the ICE Benchmark Administration and is based on five currencies (USD, EUR, GBP, JPY, CHF) in seven different maturities (overnight, one week, and 1,2,3,6 and 12 months). The three-month U.S. dollar rate is the most widely quoted rate.[2]

Every business day, between 11 and 17 leading banks contribute rates to ICE for the 35 different Libor rates (5 currencies x 7 maturities = 35 rates). The highest and lowest 25 percent of submissions for each Libor rate are excluded and the rest are arithmetically averaged to create an ICE Libor rate. Here is a simplified illustration of how a Libor rate is calculated:

Picture1

Simplified illustration of a Libor calculation. Source: BBC

Not only does Libor help determine the price of other transactions, it is often referenced as a measurement of how much confidence banks have in each other’s financial status.

Rising Libor

Libor rates have risen to their highest levels in over seven years since the end of the financial crisis. During the recession, borrowing costs ramped up due to many concerns over lending unsecured short-term money to possibly distressed financial institutions.

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3-month Libor based on U.S. dollar. Source: FRED

The recent upward trend in Libor rates is not occurring due to bank credit concerns or Federal Reserve policies, however. Many analysts believe the anticipation of regulatory changes on U.S. money market funds (MMFs) that went into effect on October 14 have been pushing Libor rates up.

The general idea of the new SEC regulations is that the unit value of money market funds will no longer be guaranteed at $1; they will float. In addition, funds can now choose to impose fees on withdrawals and even install redemption gates to help avoid massive outflows like there were in 2008. Many institutional investors are not huge fans of the new regulations because “they undermine the image of money funds as a near substitute for regular bank accounts.”[3]

There has been a major shift this year in money market fund assets out of prime funds and into government funds as a result of the regulatory changes. Now that the new SEC rules are in effect, many analysts expect the Federal Reserve’s interest rate policies should reassert its influence on Libor rates.[4]

Picture1

 

Impacts on investors

Investors with active money market funds or those who are looking to open a new account should check with their financial institution to understand how the SEC regulatory changes affect their accounts. Having full transparency on any and all potential fees and liquidity restrictions are important details every investor should be aware of across all of their investment accounts.

Investors with floating rate loans and mortgages should keep an eye on Libor rates. If Libor rates continue to rise, the cost of floating rate loans linked to Libor are going to get more expensive. If you haven’t refinanced recently, it’s a good time to shop around and see if there are better borrowing options available for your needs.

You may also want to consider increasing your savings rate. Higher interest rates makes borrowing money more expensive. But the more cash you have on hand, the less you need to borrow and the more you can lend.

Some analysts recommend exploring leveraged loan funds or Libor based floating rate funds such as the Powershares Senior Loan Portfolio ETF (BKLN). This ETF has had a steady increase in monthly dividends thanks in part to the rise in Libor. BKLN tracks the 100 largest floating-rate, high senior debt bank loan facilities issued by banks to companies. It aims to earn higher yield with less interest rate risk but comes with significant credit risk.[5]

REITs that have a larger percentage of their portfolio in variable rate loans that rise with Libor may also benefit. However, rising Libor essentially means the cost of capital is rising for borrowers. Consumers should be aware that adjustable rate mortgages and variable student loans will rise with Libor and should therefore consider refinancing. Companies with too much debt may also suffer more than companies with less debt.

If you are concerned about where interest rates are headed or worried about how the upcoming election might affect the stock market, one thing you can do is focus on increasing your active income streams.

With year-end approaching, it’s a good time to talk to your manager about your career goals and ways you can increase your earnings potential. Consider utilizing your many talents to earn some extra income on the side as well. The number of gig economy workers has grown about 27 percent more than payroll employees over the last two decades and continues to expand.[6]

Stay on the pulse

Even with rising rates, there’s no need to panic. Remember to maintain your focus on your long-term goals—successful traders have said they avoid letting their emotions get the better of them. Ultimately, how the market reacts depends on the differences between expectations and what actually ensues.

Keep an eye on Libor and the Fed in the coming months. The Federal Open Market Committee (FOMC) has two more meetings scheduled this year to discuss monetary policy and economic projections. Mark your calendar for November 1-2 and December 13-14.[7]

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[1] Leong, Richard, “Libor rise, driven by U.S. money market rules, seen topping near 1.0 percent,” Reuters, August 24, 2016.

[2] IBA, “ICE LIBOR,” Intercontinental Exchange, Inc., October, 2016.

[3] Leong, Richard, “Libor rise, driven by U.S. money market rules, seen topping near 1.0 percent,” Reuters, August 24, 2016.

[4] Rosenberg, Jeffrey, “What rising Libor is and is not telling you,” BlackRock, August 16, 2016.

[5] Tchir, Peter, “How does rising Libor impact you?” Forbes, August 13, 2016.

[6] Wells, Nicholas, “The ‘gig economy’ is growing – and now we know by how much,” CNBC, October 13, 2016.

[7] FOMC, “Meeting calendars, statements, and minutes (2011-2017),” Federal Reserve, October 20, 2016.

  1. Rob
    27 Oct at 10:03 pm

    Great insights. I’ve been thinking about interest rates a lot this year but I wasn’t aware of the regulatory changes on money market accounts.

    Reply
  2. Beatriz Gutenberg
    12 Apr at 10:14 pm

    This is nice website, i like it very much!

    Reply

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