September 14, 2016—LIBOR is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. LIBOR rates can be an indicator of stress in the financial system. Recently three-month LIBOR reached its highest level in more than seven years.  Today, the elevation in LIBOR is being attributed to the pending U.S. Money Market Reform and not some impending banking crisis.

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Source: Bloomberg

During the 2008 financial crisis, systemic risk in the global banking system caused LIBOR to reach 4.8% in October.

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Source: Bloomberg

What’s changing to Money Market Funds?

In July of 2014, the SEC adopted significant amendments to the rules that govern money market mutual funds. The new rules, set to go into effect October 14, 2016, and are intended to increase transparency as well as give investors additional protection during rare periods of market stress, when redemptions in some money market mutual funds may increase significantly.  Prime and Tax-Exempt money funds will be impacted the most by the reform as Government and Treasury funds will not.

Historically, Money Market Funds solved three distinct needs for investors: Stability/Preservation of principal, Liquidity, and Yield.  Post Money Market reform, investors will not be able to meet all three of these needs through the use of a single product.

The biggest change is that Institutional Prime and Institutional Tax-Exempt money market funds will now be required to have a floating net asset value (NAV). The daily share price will fluctuate to reflect changes in the market-based value of the funds’ investments.  Certain factors, such as interest rates or credit conditions are examples of what could cause a change in NAV.

Changes to take effect October 14, 2016

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What’s LIBOR got to do with it?

European and other non-U.S. banks have typically borrowed funding needs in U.S. short-term markets from U.S. money market funds.  As a result of the SEC’s reform, prime money market funds have become much less structurally attractive.  Over the past few months, a substantial amount of assets have shifted from prime money market funds to government money market funds creating a supply/demand imbalance which is causing Libor to become elevated.

What does a higher LIBOR mean?

Banks and other institutions who issue debt based on LIBOR will feel the pain. This will increase their funding costs as yields move higher and funding spreads widen. We do believe the environment remains constructive for high yield securities due to attractive income returns and therefore, we still maintain a modest overweight position.

Core Narrative:

We do not believe that the rise in LIBOR is a warning sign for the economy, but a technical issue in the wake of money market reform. We maintain our core narrative that growth will likely continue in the domestic economy.

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