Widening LIBOR-OIS Spread: Technical Disruption or Canary in the Coal Mine?

PGIM Fixed Income Portfolio Manager of the new Ultra Short Bond ETF (PULS), Joseph D’Angelo shares what he believes are the drivers behind this shift, what it means, and how it has affected portfolio strategy.

May 04, 2018

Since the start of 2018, we’ve seen a distinct widening in the spread between the 3-Month London interbank offered rate (LIBOR) and the overnight index swap (OIS) rate. This sudden shift brought back, for many, traumatic memories of the 2008 Financial Crisis, when this spread began to widen nearly a year in advance of the Crisis, a sign of looming liquidity problems that few heeded. Recently as this spread has begun to widen again, we sat down with Joe D’Angelo, Portfolio Manager at PGIM Fixed Income, to get his thoughts on the drivers behind this shift, what it means, and how it has affected portfolio strategy.

Q. What is the LIBOR-OIS spread?

A. The LIBOR-OIS spread is the difference between LIBOR, which is the interest rate which banks offer each other for loans in the interbank market, and the OIS rate, which is the overnight funding rate, typically the federal funds rate, that is exchanged for a fixed rate in an overnight index swap.

The spread between LIBOR and the OIS rate is considered by some to be an indicator of stress in the financial system. A widening spread between LIBOR and the OIS rate has been viewed by some market participants as a “canary in the coal mine,” indicating that banks are feeling less comfortable lending to each other and that a liquidity crisis could be on the horizon.

 

Q. Can you describe what you believe are the key drivers behind the recent widening of the LIBOR-OIS spread?

A. In summary, we see the widened spread as being largely driven by a change in the supply/demand dynamics in short-term instruments, primarily in the one-year and in maturity range.

As we entered 2018, there have been a few key factors affecting the balance of supply and demand in this part of the market.

  • While it’s been well telegraphed, the increased issuance of Treasury Bills ($846 billion of gross issuance in March of 2018) has flooded the market with a new supply of short-term government debt, pushing up yields.
    • The T-Bill rate largely drives the rate on commercial paper, very short-term securities issued by corporations to fund short-term financing needs. In the financial sector, when banks lend to each other, they lend at a premium over that commercial paper rate, meaning that a rise in T-Bills effectively means an increase in LIBOR.

T-Bill Issuance Spiked in 2018

 

Date

T-Bill Gross Issuance ($B)

January 2015

415

February 2015

393

March 2015

379

April 2015

450

May 2015

377

June 2015

367

July 2015

460

August 2015

399

September 2015

342

October 2015

315

November 2015

488

December 2015

509

January 2016

438

February 2016

506

March 2016

635

April 2016

368

May 2016

418

June 2016

530

July 2016

470

August 2016

526

September 2016

593

October 2016

507

November 2016

566

December 2016

574

January 2017

448

February 2017

488

March 2017

652

April 2017

533

May 2017

528

June 2017

600

July 2017

478

August 2017

580

September 2017

530

October 2017

487

November 2017

700

December 2017

539

January 2018

560

February 2018

611

March 2018

846

Source: SIFMA as of 3/31/2018

  • We’ve seen a major shift in how many large corporations, including some well-known names in the Technology sector, are investing their cash. Rather than investing in money market funds or other short-term debt instruments, these companies are earmarking cash for other purposes. Essentially, what was previously a large source of demand for short-term debt has now disappeared. Recent corporate tax law changes seem to be the primary driver behind this shift.
    • Cash is being divested from short-term instruments previously stored in offshore accounts as corporations seek to take advantage of the incentive for repatriating assets.
    • The accounting policy changes related to CAPEX have incentivized companies to invest in physical assets or other parts of their businesses.

 

Q. Do you think investors should be concerned this is an early sign of market distress, similar to what we saw in 2007/2008?

A. No, we do not believe that this is any sort of predictor of market distress. In 2008, all of the liquidity “faucets” were closed at the same time. There was simply no way for borrowers to get access to money, across the yield curve, across sectors and countries. While this current period of widening may seem dramatic, particularly given memories of what happened in the last crisis, the current spread has only reached 59 bps. At its peak in 2008, the LIBOR-OIS spread was 364 bps. The spread-widening dynamic we are seeing now exists almost exclusively at the front-end of the yield curve and for that reason, we believe this is a widening due to technical factors rather than the result of systemic stresses in the financial system.

LIBOR-OIS Spread Wider But Still Relatively Low

 

Date

LIBOR-OIS Spread (%)

3/30/2007

0.08%

6/29/2007

0.08%

9/28/2007

0.64%

12/31/2007

0.66%

3/31/2008

0.73%

6/30/2008

0.71%

9/30/2008

2.32%

12/31/2008

1.21%

3/31/2009

0.97%

6/30/2009

0.38%

9/30/2009

0.12%

12/31/2009

0.09%

3/31/2010

0.09%

6/30/2010

0.33%

9/30/2010

0.11%

12/31/2010

0.12%

3/31/2011

0.17%

6/30/2011

0.13%

9/30/2011

0.29%

12/30/2011

0.50%

3/30/2012

0.34%

6/29/2012

0.29%

9/28/2012

0.23%

12/31/2012

0.16%

3/29/2013

0.14%

6/28/2013

0.16%

9/30/2013

0.15%

12/31/2013

0.15%

3/31/2014

0.15%

6/30/2014

0.13%

9/30/2014

0.15%

12/31/2014

0.13%

3/31/2015

0.14%

6/30/2015

0.14%

9/30/2015

0.15%

12/31/2015

0.23%

3/31/2016

0.25%

6/30/2016

0.28%

9/30/2016

0.42%

12/30/2016

0.33%

3/31/2017

0.22%

6/30/2017

0.14%

9/29/2017

0.14%

12/29/2017

0.26%

Source: Bloomberg as of 4/11/2018

Q. What other signs would you have to see to change your opinion?

A. If this were truly indicative of a liquidity problem, we would expect to see new issues in other areas of the market challenged, but this is simply not the case. We are seeing bond offerings well received in other parts of the market, in some instances even multiple times oversubscribed. Additionally, as has happened in the past, if there were a liquidity crisis, we would expect to see more signs of borrower desperation. At this point, we see most borrowers able to complete deals with limited concessions.

 

Q. Has this dynamic affected how you are investing portfolios?

A. Yes, definitely. It has affected both how we are investing money markets as well as our ultra-short bond strategies, including the PGIM Ultra Short Bond ETF (PULS). Within money markets, we are more guarded with how we invest. Historically we might have purchased one-year maturities knowing we always had a buyer—we are now more firmly planted in the shorter-term paper (6 months or less). In our ultra-short strategies, we are moving out into the 2- to 3-year part of the curve where supply/demand dynamics are much better and balancing that with much shorter-term paper to meet our target effective duration. What we are finding, however, is that there used to be a greater roll-down benefit in 2- to 3-year maturities, but this has narrowed.

 

Q. Where do you see things going from here? Do you think the spread will get wider, tighter, or level off?

A. While we don’t see the LIBOR-OIS spread getting worse, we also don’t see it narrowing. After a tax season lull, T-bill issuance is likely to increase again. What’s more, money markets have by default become more conservative and with less roll-down incentive, money market funds are less likely to invest a little further out on the curve (1-year maturity), keeping demand low. Until corporations begin to reinvest their cash, I believe we are likely to continue to see these widened spread levels.

 

Q. What impact do you foresee this having on fixed income markets?

A. The good news is this dislocation has created an opportunity for short-term bond investors to collect a more attractive yield. The incremental yield for ultra-short bonds over money market funds ended 2017 at 23 basis points and has grown to 74 basis points (as of 3/31/2018).

Ultra-Short Bonds May Offer Attractive Yield Over Money Market Funds

 

Date

Incremental Yield (bps)

End of 2017

23 bps

Current

74 bps

Source: Bloomberg as of 3/31/2018. Incremental yield calculated as Bloomberg Barclays Short-Term Government/Credit Index yield less U.S. 3M Money Market yield.

Q. How could the replacement of LIBOR play into this?

A. We’ve investigated SOFR (Secured Overnight Financing Rate), the planned replacement for LIBOR. While SOFR has been pegged as the most suitable replacement, several weaknesses need to be addressed before it can truly be a LIBOR replacement. We do consider the possibility that as liquidity in the SOFR derivative market improves, liquidity in the LIBOR derivative market may deteriorate. Market participants may, in anticipation of this reduced liquidity, consider replacing LIBOR with OIS in certain derivatives, which could further exacerbate the spread divergence.

 

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U.S. Treasury 3M Bill Money Market Yield is the index rate used to calculate the accrual rate for US Treasury Floating Rate Notes (FRNs). The index rate equals the simple-interest money market yield on an Act/360 basis computed using the 13 week bill auction high rate. Source: www.treasurydirect.gov
Bloomberg Barclays Short-Term Government/Corporate Index measures the performance of short-term government and credit bonds.

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