Weekly Market Commentary 10/11/16

Posted on : Oct 12, 2016

Money Market Reform: Impact on Investors

Left ImageMoney market reform goes into effect this Friday, October 14, 2016, andits impact has already been felt by markets. Money market funds have historically offered a fixed net asset value of $1.00, giving investors an effective cash substitute that earns a small yield with little perceived risk. However, the failure of a well-known money market fund during the 2008 financial crisis
brought increased scrutiny to the asset class and led the Securities and Exchange Commission (SEC) to mandate reforms. Although these reforms implemented many changes, a major one is that institutional money market funds (funds where ownership includes businesses, endowments, or other non-natural persons) will no longer have a fixed net asset value of $1.00, but will instead have a floating net asset value (NAV) based on the current values of the underlying positions. Government money market funds and retail funds (those that are only held by individual investors) will be allowed to keep the fixed $1.00 NAV.

This change has led institutions to reposition their holdings, leading to net outflows of more than $670 billion from institutional prime (non-government) money market funds year-to-date, with $632 billion of those assets moving into government money market funds. The pace of movement has increased in recent months, with net assets in institutional prime money market accounts falling by more than half since the end of August (based on data from the Investment Company Institute (ICI). These flows have caused institutional prime money market fund managers to sell assets, putting upward pressure on the yields of common holdings of these funds, including certificate of deposits (CD) and commercial paper.

IMPACT ON INVESTORS
Selling pressure in CDs and commercial paper had led to higher yields for these assets, a potential positive for investors, though a small one given the limited maturity of these types of investments. The impact on the London interbank offered rate (Libor), a well-known benchmark rate that impacts more than $350 trillion in debt and contracts worldwide, potentially had a larger impact on the broader market.

The yield on 3-month U.S. dollar Libor has increased by just over 0.22% since the beginning of July 2016, with the impact nearly matching the increase seen in the lead-up to the Federal Reserve’s (Fed) rate hike in December of 2015 [Figure 1].

Bank loans, which pay a floating rate of interest determined by adding a fixed percentage to Libor, are one asset class that may benefit from the recent increase in the benchmark rate. Approximately 92% of the bank loan market (as measured by the S&P/ LSTA U.S. Leveraged Loan Index) has a Libor floor that averages 1%. Libor has been below 1% since May of 2009, which means that the average bank loan investor hasn’t benefitted from the rise in Libor yet, but may begin to soon.

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COULD THE RISE IN LIBOR BE DRIVEN BY SOMETHING OTHER THAN MONEY MARKET REFORM?

The last major increase in Libor came on the back of a Fed rate hike in December of 2015, and with the market pricing in a 68% chance of a rate hike at the Fed’s December 2016 meeting, rate hike expectations are responsible for at least part of the recent increase in Libor. Overnight indexed swaps (OIS), which tend to track with rate hike expectations, can be used to quantify the impact, and show that just over 40% of the uptick in Libor is coming from an expected increase in the fed funds rate [Figure 2].

Libor, at its core, is a measure of the rates that banks charge each other for loans in the interbank market. For this reason, the spread between Libor and OIS have historically been used as a measure of bank stress. If Libor increases faster than overall interest rate expectations, it could mean that banks are charging each other more for short-term loans, a sign that they may be losing confidence in each other. This concern has caused some to question whether the recent rise in Libor is more connected to bank fears out of Europe, or some other systemic risk.

Although this theory can’t be completely discounted, we do not believe systemic bank fears are the major driver of the recent move in Libor. The TED spread (3-month Libor minus the 3-month T-Bill yield [Figure 3]), another measure of bank stress, has ticked slightly higher in recent weeks, which isn’t surprising given concerns surrounding a major German bank. However, the overall level remains subdued compared with its level in the run-up to the 2008 crisis. Credit default swaps (CDS), a measure of the cost of insuring against default, for major U.S. banks also remain benign, suggesting bank fears are not at the heart of the recent increase in Libor. Additionally, stronger bank balance sheets in the U.S., and supportive policy from global central banks in Europe and Japan will likely act as a tailwind for banks, reducing the risk of systemic problems like those seen in 2008.

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Conclusion

Though Fed rate hike expectations and European bank fears are both likely to be a part of the story behind the recent rise in Libor, the absence of an increase in other measures of bank fears such as the TED spread and CDS makes it less likely that bank concerns are driving the rise. For these reasons, we believe money market reform is the major driver behind the rise in Libor. These reforms have been known to markets for more than two years, giving institutional investors who may be affected plenty of time to reposition assets, meaning any impact is probably already priced in and may not be likely to lead to a severe market dislocation.

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Have a great week!

We hope this weekly market commentary finds you and yours happy and healthy. Have a great week and we look forward to seeing you at Aging with Dignity on 10/27!

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Thursday, 10/27 @ the Campbell Community Center, Orchard City Banquet Hall, 2-4pm
We gathered a local team of experts to offer valuable resources and information about issues we face as our loved ones age. Experts, resources and information on:

  • Planning and legal tips for life’s second half
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Securities offered through LPL Financial, Member FINRA/SIPC.

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate. Investing in mutual funds involves risk, including possible loss of principal.
The London interbank offered rate (Libor) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The Libor is fixed on a daily basis by the British Bankers’ Association. The Libor is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year.
INDEX DESCRIPTIONS
The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to reflect the largest facilities in the leveraged loan market. It mirrors the market-weighted performance of the largest institutional leveraged loans based upon market weightings, spreads, and interest payments. The index consists of 100 loan facilities drawn from a larger benchmark, the S&P/LSTA (Loan Syndications and Trading Association), Leveraged Loan Index (LLI).

 

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