What happened with the US BOR-OIS spread ?

Since the beginning of 2018, a well-known phenomenon in crisis period is observed on the market: the widening of the BOR-OIS spread. However, the reason is pretty different this time.

  • Libor? OIS? Short reminder.

Libor

LIBOR, London Interbank Offer Rate is defined as: “The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.”

It is then a series of unsecured interest rates available for a few currencies and tenors. It is determined every day by asking a set of large banks at which rate they would be charged to borrow funds from another bank. LIBOR rates are widely used as a benchmark for loans and derivatives.

It’s very important to notice that this is a set of rates computed on a poll, not on realized transactions. LIBOR has been subject to manipulation, leading to many investigation and scandals, and is to be replaced gradually with a new rate named SOFR.

OIS

An Overnight Indexed Swap is an interest rate swap where the floating leg pays the capitalization on an unsecured overnight reference rate such as EONIA in €, SONIA in £, the Fed Funds Rate in $ and so on.

EONIA, for example, is determined by a weighted average of all the overnight unsecured lending transactions on the interbank market during a day by a set of large banks. Although it has a small and decreasing volume, it is computed on effective transactions, making it more reliable.

OIS rates are then the fixed rates for different maturities of OIS (see example below).

Overnight Indexed Swaps – {IRSB} on Bloomberg

US Libor-OIS spread is widening?

Yes, it is. Actually, it even reached over 60 bps recently, see 5Y-historic chart below:

3M US Libor-OIS spread – {LOIS} on Bloomberg

What does it tell us?

The BOR-OIS spread is usually seen as a health indicator of the credit market. It indicates the banks’ perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes (liquidity). A narrow OIS spread over LIBOR indicates a well-functioning market.

Below is the 2Y historic of the 5Y USD CDS levels for a few US banks, there is absolutely no distress signal here.

5Y CDS spread for a few US banks

Therefore, it tells us that something is happening, but we shouldn’t worry this time.

When does it really occur?

A narrow OIS spread over LIBOR (generally around 10 bps) indicates a well-functioning market whereas large spikes are observed in financial crisis periods. Let’s have a look on a 15Y historic chart:

15Y US Libor-OIS Spread – {LOIS} on Bloomberg

During 2008 crisis, when banks didn’t trust each other anymore, the spread spiked beyond 200bp. It also reached around 50bps in 2011 and 2016 during the sovereign debt crisis and money market reform.

What does explain this phenomenon this time?

Mainly, the issuance of T-bills and repatriation of offshore corporate cash thanks to US tax reforms. Let’s explain a bit more:

Lawmakers suspended the US debt limit in February 2018 (see here). A huge amount of Treasury Bills have been issued by the US government, flooding the market with debt sales and pushing up short-term corporates rates and LIBOR.

On the other hand, the tax reform (BEAT, Base Erosion and Anti-Abuse Tax) encourages corporates to bring back their cash offshore that tended to be kept on Commercial Paper and Certificate of Deposit. Therefore, the reduced demand for CP and CD makes yield rise and support the BOR-OIS widening.

Is it going to persist?

A bunch of people believes that it will since the effect of the tax reform is likely to last. The demand for CP will remain at a low level, keeping rates high. Note that some other factors influence this spread, so we can’t be sure about any direction.

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