Submitted by Grants Interest Rate Observer
If regulators on either side of the pond have their way, it will soon be time to say tata to the London Interbank Offered Rate (Libor) as the benchmark interest rate used to set the price of hundreds of trillions of dollars in debt securities the world over. Today, Bloomberg notes that the Federal Reserve Bank of New York, in tandem with the Treasury Department’s Office of Financial Research are set to debut the Secured Overnight Financing Rate (SOFR). The salient distinction between Libor and its presumed successor:
Where LIBOR relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money market funds, asset managers, insurance companies, and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets.
As financial authorities prepare to usher Libor to the exit, the benchmark reference rate has managed to make its way back into the investment spotlight. A methodical rise to 2.29% from 0.65% as the 10-year yield bottomed in July 2016 has pushed Libor’s spread over the “risk free” overnight indexed swap [OIS] rate to its highest since 2009. That type of widening would traditionally signal diminished liquidity or even credit stress.
Bhanu Baweja, deputy head of macro strategy at UBS Investment Bank, argued in an opinion piece in last Tuesday’s Financial Times that other factors explain the recent move. Baweja estimates that two-thirds of the widening can be attributed to rising Treasury bill yields (higher issuance amid the recent spending bill and tax cuts is the apparent catalyst), while the 2016 money market reform and subsequent upward pressure on commercial paper yield accounts for the rest. Baweja goes on to comment:
Does the price of funding not matter at all, then? It most certainly does. It can fundamentally alter market trends. But instead of Libor-OIS widening, which is likely a red herring, we need to focus on the right channels to detect signals of a change in the investment opportunity set.
First, watch the hit from yields to floating rate high yield credit and leveraged loans. We estimate floating rate loans to U.S. borrowers at $2.2 trillion, nearly half of which have been extended to issuers rated below double-B-minus. Our analysis shows that leveraged loan issuers will remain resilient to the next 75-100 basis point increase in Fed Funds rates, but could see their interest coverage ratios reaching dangerously low levels beyond that.
If leveraged loans are the canary in the coal mine, then so far, so good. The S&P/LSTA Leveraged Loan Total Return Index made another new high on Friday, up by more than 18% from its February 2016 interim lows.
Source: The Bloomberg
On March 15, Bloomberg noted more issuers managed to place leveraged loans at 175 basis points over Libor (the tightest spread seen since the crisis) in the prior month than in the past ten years combined. At the same time, investors continue to accept diminished legal protection, in the form of so-called covenant-lite loans. S&P Global Intelligence’s LCD unit reported Friday that cov-lite’s share of the $984 billion leveraged loan market reached a fresh record high of 75.8% in February.
Last week, Uber Technologies, Inc., which lost $4.5 billion on $7.5 billion in revenue in 2017 and recently sold shares to Softbank at a 30% markdown from its prior valuation (see “Out of gas” from the Jan. 12 issue of Grant’s for more), tapped the leveraged loan market, hoping to borrow $1.25 billion at an indicated yield of 425-450 basis points over Libor. Investor demand was strong enough for Uber to both upsize the offering to $1.5 billion and lower its spread over Libor to 400 basis points.
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