What’s Up with Libor?

Most PE firms borrow on a variable rate basis from banks. The pricing is based on LIBOR which is the acronym for London Interbank Offered Rate which is the rate at which banks are willing to lend to each other. LIBOR has often been the bellwether for real costs of credit because it is peer to peer lending and is not directly influenced by central banks. Here are the comparable statistics for 3, 6 and 12 month LIBOR at September 9, 2016. You can see that 12 month LIBOR has almost doubled over the last year and overnight LIBOR has almost quadrupled. This is a dramatic increase in the cost of short term debt.

Against this metric, however, we read every day about the threat of negative interest rates where banks and corporate issuers charge their customers to hold deposits. European bonds are being issued with negative yields where the owner of the bond gets no current yield and also takes a haircut on par value at maturity. In essence, the owner is saying “All I want is most of my money back.” Likewise depositors are paying Swiss banks to hold their cash (negative interest) but that same Swiss bank can loan its reserves overnight to another bank at more than four times the rate it could have in September of 2015. Is something rotten in Denmark? Not really, it may all come home to the US and the new money market rules that “guarantee” par on government money market funds (Won’t Break the Buck). Money market funds whose portfolio is comprised of short term corporate paper will not be guaranteed at par (They Can Break the Buck) and they also can be subject to redemption fees and gates on the amount and timing of their liquidity. Short term treasuries are rallying and short term commercial paper is oversold and quite cheap. Corporate borrowers like Home Depot are issuing 40 year bonds and then using the proceeds to arrange shorter duration portfolios to handle their expected working capital needs. I assume they see an arbitrage advantage as they expect the oversold position in short term corporates to rebalance after the money market migration to government funds is finished later this fall?

The chart shown below is from Aurum Wealth Management’s most recent report on the new world of money market instruments. It shows a dramatic shift to the government funds:

Blame It on Lehman Brothers

The money market rules trace their origin to Lehman Brothers bankruptcy in 2009 and the pressure money market funds that held its commercial paper felt to hold the $1.00 per share value (Don’t Break the Buck) when the underlying portfolio was actually worth less than par. Eventually those money market funds recovered up to 98 cents of each dollar invested but the risk to ordinary investors who believed their principal was safe was highlighted as unacceptable.

The law of unintended consequences may be at work once again. The typical PE firm cannot borrow like Home Depot and if it has not completely hedged, its portfolio has seen its bank interest rates move from 2.5-3.5% to 3.5-4.5% in just 12 months. This is great for bank profits but bad for leveraged portfolio companies. It is also a complete aberration from the rest of the commercial world where issuers are testing negative interest rates. It is unclear how long LIBOR will be influenced by the great sell off of short term, non-governmental debt. It is also unclear whether this migration will permanently affect the liquidity of the short term fixed income markets. In essence, by lending its guarantee to governmental money markets, the US Treasury is altering the highly liquid and quite dependable short term debt market. I am not so sure anyone thought about it?

Short Term Working Capital Financing

My final concern is how corporations that rely on commercial paper to finance their working capital will react to the precipitous increase in their cost of capital. While I am not an expert on fixed income and really do not know all the alternative available to corporate treasurers, I do know that the US capital markets worked quite well when there was a constant demand for short term non-governmental debt to comprise all or a portion of money market portfolios. That demand also promoted liquidity. Without constant demand and the competition with governmental money markets I can foresee a huge shift in how corporations finance their short term cash needs. Right now it looks like the government has crowded out an amazingly efficient and liquid debt market. The cost of private capital is rising and the US taxpayer is underwriting yet another government guarantee. My only question is how can I get my checkbook back?

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