In the recent weeks, London Interbank Offered Rate (LIBOR) has been on a steady uptick. The main reasons for rising LIBOR are:
1) The large increase in U.S. T-Bill issuance that regularly drains funds from the market as the U.S. Treasury funds the growing Federal deficit.
2) The tax-driven repatriation of USD profits from the Eurodollar markets (those outside U.S. borders) to the onshore markets. Usually this means sale of non-government credit and purchase of treasury bills.
3) The increase in U.S. interest rates and the risk that Treasury funding need will grow larger. This forces the market to price LIBOR higher in a precautionary manner, while continuing to price the Overnight Index Swaps (OIS) curve off the basis of Federal Open Market Committee (FOMC) rate expectations.
As seen in the chart above, LIBOR is at a very attractive level – 2.31% – at the time I’m writing this. Higher LIBOR and the current rising rate, late credit cycle environment make high quality floating rate securities appealing. Last month, I attended a panel discussing volatility selling strategies and emphasized that AA/AAA CLOs with about 3.5% yield will make many volatility selling strategies less attractive. Now, with higher LIBOR, these floating rate instruments are looking even better.
Higher LIBOR will increase the funding cost for companies with more floating rate debt. Large corporations in S&P have mostly financed themselves using fixed rate bonds. However, 40% of Russell 2000 companies’ debt is floating rates. This justifies a cautious stance towards small cap companies in general.
Rising LIBOR is not a sign of market stress. It is driven by technical criteria. Higher LIBOR makes floating rate securities attractive, so be cognizant of companies with high exposure to floating rate financing in this environment.
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