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Libor-OIS, what is the story?

In the US, the Libor has risen by 63pb since early January to reach 2.3%. The Libor is the rate at which banks lend money to each other. The difference between this rate and the OIS (“Overnight Indexed Swap”) has reached 60bp, its highest level since May 2009.

The explosion of this spread in 2007 was a precursor to the subprime crisis. The context today is different. Investors are not worried about the quality of bank fundamentals.

The sharp rise in the issue of Treasury Bills in the first quarter of 2018 is a regularly advanced explanation. The increase in the supply of US treasury coupled with the reduction of the Fed  balance sheet have reduced the global amount of liquidity. However, this explanation is insufficient: the T-bill interest rate has remained a lot more contained than that of the Libor.

US companies have become a major player in the US commercial paper market in recent years…

1)     Collapse of the prime funds in 2016. Following the Money Market reform (MMF reform) in 2016, the regulation has hardened  for prime funds (funds containing short-term debt securities of private issuers). Consequently, $900bn moved from the prime funds to public funds. Outstanding premium funds fell to $0.4 trillion from $1.3 trillion.

2)     In recent years, US companies have bought huge amounts of corporate bonds. Cash-rich US companies have accumulated huge amounts of profits abroad. This cash has been partly invested in CP (Commercial Paper – debt security issued by companies on the money market).  According to Bloomberg, the 50 top overseas cash holders in the S&P 500 have parked $925bn of their cash and marketable securities outside the US.

…The Donald Trump’s tax reform is changing the balance between supply and demand for commercial paper. We believe that it matters a lot vis-à-vis this Libor-OIS spread.

3)      The new tax reform will encourage companies to repatriate profits held abroad by lowering the cost of repatriating cash overseas from 35 percent to 15.5%. Cash repatriation will reduce the purchases of commercial papers (and the issuance of long term-debt). Companies will use cash repatriated to fund notably M&A activity and share buybacks

4)      US CP outstanding recently hit the highest since MMF reform. In particular, foreign banks have increased issuance on the US CP market: 1) need to replace USD funding following the repatriation of foreign earnings by US companies and 2) the tax reform “base erosion and anti-abuse tax” (BEAT) is encouraging banks to raise funding with commercial paper instead of currency swaps.

What are the consequences? It remains uncertain exactly how and when companies will finalise their repatriation plans. These tensions look set to continue to weigh on spreads. If this situation were to last, it is sure to draw the attention of the Fed. Higher Libor has an impact on “fundamentals”. A higher Libor means a tightening in financing conditions: the Libor has a direct effect on the amount US households pay for adjustable-rate mortgages and consumer loans. Furthermore, the cost of funding in dollar has increased for foreign subsidiaries.

2018-04-09
AINOUZ Valentine , CFA, Credit Strategy
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Libor-OIS, what is the story?
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