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Big Leap for Libor

The London Interbank Offered Rate, a floating-rate index used by many municipal market participants, jumped dramatically last week amid claims the banks reporting the rate were artificially providing low numbers. For muni market participants, exposure to the elevated rate has wide-ranging implications.

Libor plays a behind-the-scenes role for a host of securities and transactions: as a benchmark index for setting minimum and maximum rates in auction-rate security auctions, in swaps that pay a variable rate based on Libor, and as part of hedging strategies that make bets on the correlation between the municipal curve and the Libor curve. For more typical municipal bonds, the changes in Libor will have little effect.

"For the muni cash bond market there is no immediate impact," said Ying Chen Li, a municipal strategist with JPMorgan.

On Friday, the three-month Libor was 2.91%, up 37 basis points from where it was one month ago, according to Bloomberg data. Between Wednesday and Friday of last week the rate jumped eighteen basis points from 2.73%, with the 9 basis point gain between Thursday and Friday the largest increase since August 9.

The move came after the British Bankers Association, which sets the rate each morning in London, said it was accelerating a scheduled review because of concerns that banks reporting the rate may be giving artificially low numbers. Libor is calculated by collecting lending rates from 16 banks, excluding the outliers, and averaging the middle eight results.

On its own, an uptick in Libor rates helps the municipal market. But the volatility in the rate, further exposed by the recent spike, makes it difficult to depend on the historic correlation between Libor and tax-exempts.

In the auction-rate market, an increase in Libor can bring some relief. In many cases, the minimum and maximum rates for auctions are tied to Libor. Market sources have said that auctions have been failing because max rates were setting at below-market rates, leading to a lack of demand from investors who sought higher yields. If Libor continues to increase, as some analysts expect, it could raise max rates and bring them closer to market rates, which could result in a drop in the number of failed auctions.

Other tax-exempt market rates are tied to Libor as well, including the variable rate paid to counterparties in some interest rate swaps. With some swaps, the issuer pays a fixed rate and receives a variable rate in return. When the variable rate is tied to Libor, an increase in the rate means issuers are getting paid more, bringing the payment closer to the level the issuer needs to cover the debt service payments on the fixed-rate debt tied to the swap.

Some securities are also dependant on Libor, including a type of bond popular in the early part of last year called Libor floaters. About $10 billion of these bonds - in which an issuer pays a variable rate tied usually tied to the three-month Libor - are currently outstanding, Li said. Those who have sold these bonds will see debt service payments increase with gains in Libor.

"For those Libor index floaters directly related to the 3-month Libor index, there is going to be an increase," Li said. "But the absolute level of increase is not that much."

And for those who use Libor to hedge, the increase could cause the rate to cheapen relative to high-grade municipals. Muni out-performance over the last month on the long end of the yield curve has helped the relationship, but further increases in Libor are needed to bring it back in line with historical averages.

On March 20, 30-year high-grade municipal yields reached historically high levels of more than 109% of the Libor yield, according to Peter DeGroot, municipal bond strategist at Lehman Brothers. Over the past month, the ratio has fallen and as of April 17, the ratio was at about 93%, DeGroot said. The average over the past year is about 83%, according to Municipal Market Data. Investors expect the ratio to return to the average.

"On the surface its good if it cheapens Libor," said Matt Fabian, managing director at Municipal Market Advisors. "But it's bringing more volatility."

The volatility and the recent uncertainty about banks keeping Libor artificially suppressed accentuates the recent decoupling of the Libor-to-muni relationship. As this relationship becomes less reliable - if it does not revert to the historical average - hedged investors will find additional difficulty in protecting themselves from the exposure to tax-exempts.

"There's been a correlation breakdown," DeGroot said. "This has led to a significant amount of uncertainty in trying to insulate a long municipal bond position from interest rate and basis risk."

The volatility is a result of the broader credit crunch, which has called into question much of the quantitative and relational data that investors have counted on in recent years. As a result, many institutional investors have chosen to reduce their positions or headed for the sidelines.

"You can't use data the same way today as you could three months ago," Fabian said. "Every kind of data should be viewed with a bit more skepticism."

 

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