On Demand

On Internal Indexes, like LIBOR

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When I was a life actuary, following the deferred annuity market, the concept of market-value-adjusted annuities arose. Annuity values could react like bonds to:

  • An external index rate, or,
  • An internal index, driven off of the new money rate for annuities

Now, the internal index sounds soft, but it is not so. Yes, you can lower your new money rate but reserves grow on indexed products. You can raise your rates, but reserves will shrink. It's not perfect here, but the internal index will work over the long haul.

So when I look at LIBOR and potential manipulation, I don't see a lot of reason for concern.

When bond deals are priced, the relative yield is what is priced; it does not matter what the benchmark is, roughly the same overall yield would have been obtained. Spreads are a way of expressing the excess yield over equivalent maturity government or AA bank (swap/LIBOR) yields. They are a result of the process, not a driver of the process.

If 3-month LIBOR were replaced by the on-the-run 3-month Treasury yield, new deals would be priced, and the spreads would be higher by the TED (EuroDollar - Treasury) yield spread.

When I was a bond manager, dealer desks would often try to sell or buy bonds off of unusual benchmarks. I would always make the necessary adjustments to calculate the option adjusted spread over interpolated swap rates, with further adjustments for the degree of premium or discount to par. (Note: A premium bond carries extra credit risk because if it defaults, the most you can recover is par. Opposite for discount bonds. There is a mathematical method for calculating the amount of yield tradeoff between premium/par/discount bonds, even in the absence of a credit default swap [CDS] market. You assume that the spread over swap is the CDS premium, and calculate the annual cost of insuring the premium to par. Deduct that from the current spread, and you have the hypothetical true par spread. Once you have that, you can make rational swap trades.)

What I am trying to say is that benchmarks/indexes aren't all powerful. Bright bond investors look past them, and analyze the economics of the situation. Same for intelligent borrowers; they know that LIBOR rises during times of financial stress. If you are a floating rate investor/borrower, you ought to analyze the rate that your investment/loan is tied to.

Many commentators with knowledge of the situation think that lawsuits regarding LIBOR will amount to little (one, two). Yes, there may have been some manipulation in a micro-sense for some banks, but in terms of having a big effect on many, I don't think that is possible. There might be some degree to which borrowers benefited and savers/lenders lost. That's a tough case to press on any side. Courts favor borrowers, and they benefited from any manipulation.

In closing, I don't think much will come from the "LIBOR scandal" the same way that nothing will come from the "rating agencies scandal." Both are examples of summarizing information/opinions that investors can use at their own risk. They are not fiduciaries; those who use the information do so at their own risk.

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About the Author

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that. In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. My chief responsibility will be to develop economic analysis with equity and fixed income strategies and provide advice to the firm’s sales & trading staff and its client base. Beyond that, we hope to develop my value investing into a product for out clients.

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