LIBOR — What Is It, and Why Should You Care?
Alan ZabloudilDirector, Capital Markets
Nov 15, 2016
There are a variety of resources investors can use — one of those being the LIBOR — to help them in their investment decisions and gauging the behavior of interest rates.
I know what you’re thinking: “Another article on interest rates — exactly what I want to read again.” While you may debate which areas of that sentence should be emphasized, it’s undebatable that interest rates continue to be a red-hot topic among investors and financial advisors as they continue to grapple with the positioning of portfolios to weather any central-bank-initiated storm. While the road ahead remains unclear, the Federal Reserve (Fed) has dropped a few breadcrumbs that suggest the economic data is strong enough to support an increase in the federal funds rate.
Without a crystal ball to see the future, there are some questions we can ask to try to get an idea.
- What are market participants telling us about the direction and timing of interest rates?
- How can we use the LIBOR in relation to other key benchmark rates to our advantage?
What is LIBOR?
The London interbank offered rate, better known as LIBOR, provides an indication of the average rate at which a LIBOR contributor bank can obtain unsecured funding in the London interbank market for a given period, ranging from overnight to 12 months, in a given currency. It’s created by using a reference panel of 11–17 global banks such as Lloyds TSB, Barclays, Citibank, Credit Suisse, Bank of America, Royal Bank of Canada and so on.1 Each bank is asked the following question:
“At what rate could you borrow funds if you were to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?”
Each response from the contributing banks will be perceived to be the lowest, best rate possible; upon submission, the rates are ranked in descending order, and then the highest and lowest 25 percent of submissions are excluded. This trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation (see Figure 1).
Investors use LIBOR to help determine short-term interest rates in currencies such as the Swiss franc (CHF), the euro (EUR), the British pound sterling (GBP), the Japanese yen (JPY) and, the most commonly quoted LIBOR rate, the U.S. dollar (USD). The most recent estimates from the Intercontinental Exchange state that approximately $300 trillion USD is directly tied to LIBORs globally, which makes it a broad-based multinational representation of interest rate expectations.22 It’s especially useful for institutional investors who need to hedge interest rate exposure in countries where liquid government bond markets are not present, as it is the basis of settlement of interest rate contracts for major futures and option exchanges.
On a macro level, as is the case with any interest rate measure, LIBOR can be used as a measure of the overall health of the banking sector, providing indications of risk in lending short-term unsecured funds to other banking institutions. This is similar to counterparty risk — any interest rate is made up of components that represent risk. It always starts with the risk-free rate (such as U.S. Treasury debt), and then premiums (such as inflation expectation, default risk, term risk and liquidity risk) are added to arrive at the nominal interest rate.
From a consumer perspective, we can experience the LIBOR when we borrow or lend funds with variable rates, such as in loan documentation of mortgages or student loans. This usually shows up when we see interest rate changes on our statements following a global interest rate change. We can also use this rate to be able to help us determine frequency and magnitude of interest rate changes, which is beneficial when it comes to investment planning. Such a determination is achievable due to the real-time, real-life feedback we receive from the contributing banks on their abilities to obtain financing from each other. Because LIBOR is a global effort, it allows investors to obtain a broader reach into reasonable rates.
Having a working knowledge of LIBOR has some predictive properties when trying to determine interest rate paths in the near future. As shown in Figure 2, contributing banks started pricing in an increase in interest rates well before the Fed increased the overnight fed funds rate after its Federal Open Market Committee (FOMC) meeting on Dec. 16, 2015. The three-month U.S. LIBOR, the most commonly quoted LIBOR, began to tick up starting early in November last year, and we currently observe the same reference rate beginning to move higher in recent months. However, many analysts suggest that this increase was primarily due to the SEC’s money market reform as well as political forces that have been pushing the rate higher during this most recent divergence. As of Nov. 10, 2016, Bloomberg analysts suggest a greater-than-80-percent probability of an interest rate hike at the Dec. 14, 2016, FOMC meeting.
In an increasing interest rate environment, who is affected the most, and which industries will feel these effects most significantly? As mentioned previously, investors with floatingrate debt or mortgages should expect to see their debt expenses increase. If you are lending at this rate, the vehicle will reprice to reflect the step up in the interest rate, resulting in greater yield. If you are borrowing, it might be time to look at refinancing options. REITs will benefit in this environment if they hold portfolios of variable rate loans, though this will also present a higher cost of capital to overcome.
The financial sector will feel this impact the most, as credit card portfolios will reprice, and any other variable loan products will result in higher income stream to this sector as long as this debt is not refinanced at a more favorable rate. Lastly, any industry that has historically maintained a high debt load could feel this effect once the rates step up, which could affect their profitability and — at the most extreme situations — their solvencies.
There has been an enormous amount of change occurring in our country recently, which has affected all of us in different ways. The markets are no different — they love stability and some level of predictability.
We have had new regulations introduced into our economy that have sent shockwaves through investment vehicles and have survived a highly contested and divisive U.S. presidential election. All of these items are priced into our investment universe. It’s time for us to look ahead and to position ourselves in the best possible way we can to weather any storm that comes our way. The use of proper asset allocation and asset class diversification could buffer some of the volatility inherent in this type of environment.
Applying information like the LIBOR will provide you an extra device in your toolbox that will give you confidence in your investment decisions. Now would be an excellent time to contact your financial advisor to discuss your financial plans and ensure that you are still on the right path to achieve your financial goals in this changing-rate environment. Are you saving enough in order to compensate for rising interest rates? Higher rates make borrowing money more expensive and will eat into your savings ability, but the LIBOR can help you identify opportunities to make changes in your expectations.
All opinions expressed and data provided are subject to change without notice.
Some of these opinions may not be appropriate to every investor.
Index performance does not reflect the deduction of any investment-related fees and expenses. It is not possible to invest directly in an index.
Asset allocation/diversification of your overall investment portfolio does not assure a profit or protect against a loss in declining markets.
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