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HomeMarketsKey global rate nears 1% for first time since 2009

Key global rate nears 1% for first time since 2009

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The global benchmark interest rate for trillions of dollars of corporate loans, credit cards and derivative contracts is approaching 1 per cent for the first time since the US emerged from recession, as global markets reach the end of a turbulent week.

With the US Federal Reserve anticipating greater US economic strength in 2017, this has pushed the dollar to a 14-year high and spurred further selling across bond markets. The policy-sensitive two-year US Treasury note yield approached 1.3 per cent this week for the first time since 2009, after the US central bank indicated that it may raise borrowing costs three times during 2017, up from a prior forecast of two tightenings.

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Alongside the bearish shift in bond markets, the stage has been set for higher borrowing costs for companies, with a key short-term US dollar money market rate, the three month Libor, climbing to a seven-year high of 0.997 per cent on Friday.

Analysts at Bank of America Merril Lynch expect Libor will set modestly higher through the end of the year, with the three-month ending 2016 between 1 and 1.05 per cent.

As rates rise, a flood of money has found its way into loan funds, as investors seek out the higher income paid by floating rate loans, unlike fixed rate debt. Bank loan funds have counted more than $3bn of inflows over the past two weeks, the greatest haul for a two-week period in more than three years, according to data from EPFR.

“Investors are saying we’ve got a new interest rate environment, [Libor] will be trending higher for a while. Let’s find leveraged loans,” said Daniel Kelsh, fixed-income strategist at UBS Wealth Management Americas.

US Libor forms the base for most leveraged loans, with companies agreeing to pay a fixed cost above the rate based on their creditworthiness.

A Libor setting above 1 per cent will break through one of the so-called “Libor floors” that gained widespread use after the financial crisis. The floors, which guarantee Libor at a certain level and provide minimum returns for leveraged loans, were introduced to make the loan market more appealing to investors after Libor tumbled in 2009.

As Libor sets higher, the floors are eroding payments in bonds backed by leveraged loans known as collateralised loan obligations.

The 1 per cent Libor floors provided an added pick-up to so called “equity holders” who hold the riskiest portion of the underlying loans in CLOs and are rewarded with the remaining income generated by the loans after other investors have been paid.

More than 60 per cent of loans in the S&P/LSTA Leverage Loan index contain a Libor floor of 1 per cent, amounting to $545bn of obligations, according to S&P Global Market Intelligence.

However, the gains have been eroded as the benchmark interest rate has climbed towards the floor.

“You would have reaped a huge benefit from the floor effect over the past few years,” said Chris Acito, chief executive at Gapstow Capital Partners.

In contrast with the US this week, short-dated German bond yields fell to fresh negative lows as investors sought debt that could become eligible for the European Central Bank’s quantitative easing programme.

The yield on Germany’s two-year schatz, which moves in the opposite direction to its price, fell two basis points to minus 0.8 per cent on Friday — its lowest on record — reflecting higher demand after the ECB said it was removing a yield floor of minus 0.4 per cent on its purchases of sovereign debt at its recent monthly policy meeting.

Under the initial terms of its quantitative easing programme, the ECB was limited to buying government bonds yielding above -0.4 per cent and between a 2-30 year maturity. It has now scrapped the yield floor and extended its minimum maturity to one-year.

Additional reporting by Elaine Moore

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