Implications of LIBOR - OIS Spread

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Ellen Chenoweth, Associate Investment Strategist - FlexShares Exchange Traded Funds

Market volatility returned with a vengeance during the first quarter and many investors think the situation could continue for the foreseeable future. We believe the dynamic is being driven by a mix of constructive economic fundamentals, a Federal Reserve in tightening mode and turbulence in both geo-political and policy spheres. The ramp up in volatility has generated a lot of chatter about the merits of paring back portfolio risk by shifting from higher beta assets into fixed income or liquidity assets. One caution flag cited by some considering a move into liquidity investments is the recent behavior of a key relationship within the bond market – the LIBOR-OIS spread.

LIBOR-OIS has grabbed headlines lately because the spread has climbed to its highest level since May 2009. Among other things, the LIBOR-OIS spread is used to gauge credit conditions in the banking system. Despite well-documented flaws revealed during the credit crisis, broadly speaking the London Interbank Offered Rate (LIBOR) is seen to represent the average interest rate that banks are willing to lend to one another for unsecured loans of one year or less. Stress in the financial system or a slowing economy often coincides with a decline in the quality of bank assets (i.e. loans); these situations are reflected in higher bank funding costs and an increase in LIBOR rates that accounts for rising credit risk. Contrastingly, the Overnight Indexed Swap (OIS) rate is used to represent the interest rate controlled by the Federal Reserve. In the United States this is the federal funds rate. Investors use this as the benchmark risk free rate for discounting cash flows of swaps and other over the counter (OTC) transactions. The spread between LIBOR and the OIS then is viewed as the difference between a rate with credit risk and one without such risks. During the financial crisis the LIBOR-OIS spread was an important early indicator that the banking system and the economy were heading for trouble.

3 month LIBOR – OIS Spread

Should the recent rise in the LIBOR OIS spread cause concern for investors considering liquidity products? We think the current spread behavior is a function of technical considerations rather than a signal of worsening credit conditions at banks. There are two points underpinning our view. The first is that the supply of Treasury Bills (T-Bills) from the US Treasury has increased for a variety of fiscal and tax reasons. The second is that the demand from corporations for short term debt which typically is defined as debt that matures within the next 5 years, has cooled appreciably. Specifically, the cash previously held overseas by corporations and now being repatriated is being redeployed into capital expenditures (e.g. upgrading equipment) and capital actions (such as buybacks and dividends) instead of being invested in short maturity debt. An increase in the supply of T-Bills paired with sharply reduced demand for all types of short maturity debt by corporations, which historically are a key investor in these types of investments, is pushing up rates at the short end of the yield curve,* including LIBOR. We think these developments are transitory and do not indicate a reason to fear liquidity credit markets.

* The yield curve is constructed by plotting yields for various maturities. The short end of the yield curve are those maturities under 5 years.

A recent increase of investment flows into short (invests in instruments with maturities of up to 5 years) and ultrashort (invests in instruments with maturities of up to 1 year) bond funds indicate a segment of investors may be attracted to liquidity products. Some might be motivated to balance overall portfolio risk while others may be building up reserves to redeploy in the event of further correction. FlexShares Ready Access Variable Income Fund (RAVI), a liquidity product, is designed to maximize current income and maintain an average duration of one year or less. These types of products may offer straightforward trading for some investors. Such products attempt to achieve their objectives by investing in short maturity investment grade securities that provide a potential yield advantage over government securities. The recent uptick in the LIBOR-OIS spread has made yields in short term corporate debt relatively more attractive compared to like duration** government securities. For investors whose portfolio might benefit from incremental credit risk, products like RAVI may generate additional yield while also dampening potential portfolio risk.

** Duration is a measure of the sensitivity of the price – the value of principal – of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.


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FlexShares Ready Access Variable Income Fund (RAVI) is actively managed and does not seek to replicate a specified index. Additionally, the Fund may invest without limitation in the fixed income and debt securities of foreign issuers in both developed and emerging markets. The Fund is at increased credit and default risk, where there is an inability or unwillingness by the issuer of a fixed income security to meet its financial obligations, debt extension risk, where an issuer may exercise its right to pay principal on an obligation later than expected, as well as interest rate/maturity risk, where the value of the Fund’s fixed income assets will decline because of rising interest rates. The Fund may also be subject to increased concentration risk as it may invest more than 25% of its assets into the securities of a single developed market. Additionally, the Fund may invest without limitation in mortgage or asset-backed securities, which puts it at increased risk for interest rate/maturity risk, debt extension risk, and prepayment (or call) risk. Also, the Fund is "non-diversified" under the Investment Company Act of 1940, and may invest more of its assets in fewer issuers than diversified funds.