Jerome M. Schneider
U.S. money market reform will take effect on 14 October 2016, and short-term interest rates such as Libor (the London Interbank Offered Rate) have been
rising significantly in anticipation. Jerome Schneider, PIMCO’s head of short-term portfolio management and Morningstar Fixed-Income Fund Manager of
the Year (U.S.) for 2015, addresses five critical questions we’re hearing from investors about what to expect next and the implications for portfolios.
Q: Should investors and issuers be prepared for even higher Libor levels in the weeks and months to come, or have we already seen the most significant
Anticipation of U.S. money market reform has pressured short-term funding rates higher as U.S. investors move toward money market funds that invest only in
government securities and away from prime (credit) money market funds. As a result of this diminished appetite (as reflected in past and expected
redemptions in prime money market funds), issuers of commercial paper and certificates of deposit, mainly non-U.S.-domiciled banks, have to pay more for
funding as yields move higher and funding risk premiums widen. As a result, many funding benchmark rates, including U.S.-dollar-denominated Libor resets, have seen dramatic increases of more than 50 basis points (bps) over the past
year – and less than half of that increase can be attributed to the 25 bp hiking action by the Federal Reserve last December.
While prime money market funds have raised a lot of liquidity in preparation for the reforms, the “known unknown” factors remain steadfast: How much
additional outflow can we expect, and over what timeframe – will 14 October be the turning point, or will outflows continue into 2017? To hedge these known
unknowns, we think many prime fund managers will continue to buy shorter and shorter maturities (see Figure 1) and invest more and more in
government-related paper to fund potential outflows. This should keep upward pressure on Libor during the weeks ahead. Our base case is for the Libor-OIS
spread (i.e., the difference between Libor and the overnight index swap rate,
which is often benchmarked to the fed funds rate) to peak in early October at about 5 bps – 10 bps higher than the current level of roughly 40 bps (as of
25 August). More importantly, we believe that the Libor-OIS spread (and hence relative Libor rates) will remain cyclically elevated beyond October as banks
and investors adjust to a significantly diminished investment base and new rules governing prime funds.
Q: What are the downsides of higher Libor rates?
Banks and other debt issuers who utilize Libor-based floating notes or commercial paper will feel the pain of higher Libor, paying more for funding as
yields move higher and funding spreads widen. Such institutions need to realize that what they are experiencing is a structural change, not simply
an episodic period of upward repricing. As such, these institutions should reevaluate their capital structures in light of these altered conditions and
potentially seek longer-maturity or more diversified funding sources over time.
We also note that the vast majority of these higher rates is paid by institutional issuers of credit (and especially non-U.S.-domiciled banks) who have
floating rate debt outstanding. For individuals, the pain of such increases is for the most part limited to those who have mortgages tied to Libor resets,
which is less than 20% of the U.S. residential mortgage market (according to the Wall Street Journal).
Q: Could the Libor rate be driven down, or at least stabilized, by increasing demand from investors outside the money market sphere?
It’s important to remember that this is not simply a market reaction to a piece of data, but a structural reform that will change the way most investors
allocate their cash liquidity over time. So while this year’s spike in Libor reflects the initial market reaction to money market reform, it will take
months if not several quarters for rates to recalibrate to lower levels again relative to perceived “risk-free” rates such as OIS or the fed funds rate.
And don’t expect once the October implementation date has passed for levels simply to recalibrate back to thresholds we observed earlier in 2016. And yes,
as with any free market, repricing of assets will invite new participants to consider investing in short-term paper, which eventually should limit the rise
of dollar-denominated Libor spreads for issuing financial institutions.
Q: For investors focused on liquidity and short-term assets, does the increase in Libor signal a potential opportunity?
It absolutely presents a unique opportunity for those investors willing to assess and adapt to this structural evolution. Money market reform really isn’t
“new news” to most investors at this point, although its effects might appear to be newsworthy of late. As an active portfolio manager, PIMCO has been
anticipating money market reform for more than two years, opportunistically positioning our short-term capital preservation strategies to seek additional
returns ahead of the effective date in October.
For example, we are overweighting floating rate assets that are indexed to Libor because we expect banks will continue paying relatively higher funding
costs for the foreseeable future as a result of these structural changes.
Another avenue of opportunity we would seek to capture is the emerging demand for U.S. dollars by foreign investors. Strategies that seek to lend U.S.
dollars on a fully hedged basis to foreign investors have a unique and attractive tailwind that allows them to invest dollars at attractive yields compared
with investing only in U.S.-dollar-denominated assets such as U.S. Treasury bills or notes.
Q: How should investors be thinking about the bigger picture of short-term portfolio positioning in light of money market reform and the rise of Libor?
At PIMCO, we have been anticipating this structural change in Libor for years. For some time we have viewed floating rate assets as an attractive trade,
and we will continue to evaluate other opportunities that emerge from money market reform.
We believe the most important thing for investors to realize is that this is an evolutionary process. The new era calls for comprehensive resources that
are able to assess the changing landscape of liquidity management and to understand and successfully navigate the new regulatory frameworks, which require
new paradigms for capital preservation strategies beyond solely utilizing traditional money market funds.
Investors also should acknowledge how these structural changes are likely to affect their investment outcomes and risk profiles. Active and innovative
management of liquidity in this new era will likely be critical to preserving not only liquidity, but also purchasing power for their capital over time.
Traditional approaches to liquidity management that don’t embrace these structural modifications may fail to do both.
The "risk-free" rate can be considered the return on an investment that, in theory, carries no risk. Therefore, it is implied that any
additional risk should be rewarded with additional return. All investments contain risk and may lose value.
The Morningstar Fixed Income Fund Manager of the Year (US) award is based on the strength of the manager, performance, strategy, and
(London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans.
Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The
value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more
sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment
increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond
investments may be worth more or less than the original cost when redeemed. Floating rate loans are not traded on an exchange and are
subject to significant credit, valuation and liquidity risk. Currency rates may fluctuate significantly over short periods of time and may
reduce the returns of a portfolio. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for
informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment
product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be
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America L.P. in the United States and throughout the world. ©2016, PIMCO.
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