Bond crash/course: LIBOR

I had planned to write about swap spreads, but it turns out I need to discuss something else first.

In my post on credit spreads, I wrote:

Since the Treasury has perfect credit, yields on Treasuries capture every concern of the bond market — opportunity costs, inflation risks, etc. — except for credit. All of those other concerns are identical for any bond with the same maturity, coupon, etc.; the only concern that is specific to the issuer is credit. Therefore, we can isolate the credit of any issuer by comparing the yield on its bonds to the yield on comparable Treasuries.

So when people talk about “interest rates” in general going up or going down, they are talking about Treasury yields, from which all others follow based on their credit.

This was a bit of a lie, and understanding how and why is the point of this post.

First, let’s write the concept as a trivial equation:

yield = risk-free yield + issuer-specific credit risk

Note that all of these are market-determined values. This equation says that the market-determined yield for a bond can be decomposed into the market-determined risk-free yield plus the market-determined credit risk of the issuer.

What use is this? Well, suppose you are an investor with deep knowledge of Company X. You have expended enormous effort studying the industry, poring over financial statements, building models, talking with management… And you have concluded that the market is overestimating the risk for Company X, so you want to buy their bonds. That is, you think you know more than the market about Company X and want to use your knowledge to make money, aka. “create a more efficient market”.

Just one problem: The yield on those bonds depends not only on X’s credit risk, but also on the yield of “risk-free” Treasuries. Treasury yields in turn depend on market expectations (and uncertainties) concerning macroeconomic factors like inflation, economic growth, etc. And although you think you know a lot about Company X, you have no reason to think you know more than anybody else about all those macro factors.

So what do you do? You hedge, by buying Company X’s bonds and shorting comparable Treasuries. Then you do not care if interest rates in general go up or down, and everything is peachy in your cleverly-built bond portfolio.

That is, until 1998 rolls around, LTCM collapses, and suddenly everybody in the world wants to own nothing but Treasuries. All other bond yields skyrocket (i.e., prices fall). Treasury yields collapse (i.e., prices rise). Suddenly, your long-X + short-Treasury portfolio does not look very clever at all. What happened?

What happened was that your assumptions were wrong. The true equation for yield looks more like this:

yield = risk-free yield + issuer-specific credit risk + systemic credit risk

In other words, there is a systemic factor at work that affects the yields of everything but Treasuries. In normal times, this factor is small and pretty much constant, but during times of financial distress, it can move far and fast. If only we had some way to isolate this factor, we could use it to better isolate issuer-specific credit risk.

Enter LIBOR. The basic idea is that nobody trusts anybody more than large international banks trust each other. (This is the customary assumption, so we will run with it.) In other words, if we look at the yields that large banks charge each other for loans, we will observe something very close to a risk-free yield plus the systemic credit risk. This provides a superior basis from which to calculate a spread or to hedge a portfolio.

Policymakers — e.g., central banks — have an interest in systemic credit risk, so they also watch LIBOR spreads closely. The TED spread is the difference in yield between 3-month LIBOR and 3-month Treasuries, and thus it is a fairly pure indicator of the systemic credit risk at the 3-month maturity. When it exploded last fall, normally sanguine people started freaking out.

LIBOR is calculated daily by asking large banks how much they are charging each other for loans of various maturities, specifically overnight, one week, one month, two months, three months, six months, nine months, and one year. And because it captures all of the systemic factors relating to yields, LIBOR is used all over the place to calculate spreads, define terms for “adjustable-rate” instruments, and hedge portfolios.

It is impossible to overstate how fundamental LIBOR is to the bond market. When people talk about “interest rates” in general, they actually mean LIBOR. And thus have I corrected my earlier lie.

But wait a minute. If LIBOR only exists for maturities less than one year, how exactly do we apply it against instruments of longer maturity? Don’t we need some kind of “LIBOR yield curve”?

Next time: Swap spreads. For real.

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