Despite headline news of near zero interest rates, interest rates have been rising. For those of you who work in finance or accounting, then you would be familiar with LIBOR, which is the London Interbank Offered Rate. It is a benchmark interest rate that some of the world’s leading banks charge each other for short-term loans. It is also used similarly like a prime interest rate that commercial banks charge their clients. 3-month LIBOR has sharply risen for 2+ years by more than 60 basis points, from less than 0.25% in mid-2014 to 0.85% last week.
Things are Changing
The yields on 3-month treasury bills, which are deemed virtually risk-free, have risen, too, but by much less. As a result, the difference or spread between these two 3-month interest rates (commonly referred to as the TED Spread) suggest credit risk, particularly in the banking system, is on the rise. In the past, the TED Spread has spiked before and during times of financial stress.
The problem with using the TED Spread right now is that there are structural changes in money market funds, which commonly invest in LIBOR-related securities. To make money market funds less risky, new rules now make investing in LIBOR-related securities less attractive, which has reduced their demand. To attract demand, LIBOR-related securities need to provide higher yields, which is what has happened.
With that in mind, I have looked for another way to gauge financial system risk in a similar, easy-to-understand way, like the TED Spread, but without the structural issues. I think I found it. Both financial and non-financial companies issue commercial paper, which is basically unsecured, short-term, promissory note. Since there is no collateral backing it, only large firms with superior credit ratings have access to this credit market.
Given both are high in credit quality (AA-rated) and short in duration (3 months), this allows us to compare them on an apples-to-apples basis. The main difference between these two types of commercial paper is financial sector risk, which can be estimated by the difference or spread between their interest rates. Though here is no formal name for this type of spread, I have decided to call this the Financial Paper Spread (“FP Spread”).
Financial Sector Risk Has Clearly Risen
As you can see in the graph above, the FP Spread going back 19+ years is normally a mere 3 bps or 0.03%. That noticeably changed in late-2007 when cracks in the financial system began showing. The FP Spread eventually spiked as markets around the world crashed due to the Global Financial Crisis.
As of last week, the FP Spread reached 25 bps or 0.25%: that is more than 7-times the 19+ year median! Such a level is abnormally high, to say the least. In fact, last week’s reading ranks at the 93rd percentile. Just six weeks ago in mid-August, the FP Spread got as high as the 95th percentile. As shown in the graph, the FP Spread has returned to a level consistent with past financial crisis.
Whether or not you find the spread between financial and nonfinancial commercial paper a reliable indicator of financial sector risk, please consult an investment fiduciary before making any investment decisions.