The credit crisis of 2007 challenged some long-held assumptions about how greatly central bank policy can influence the behaviour of financial markets and institutions. Efforts by the US Federal Reserve, the European Central Bank (ECB) and the Bank of England (BoE) to inject more than $1 trillion into global money markets to boost liquidity throughout the second half of the year met with limited success as banks remained stubbornly reluctant to lend to each other.
That reticence was best illustrated by the sharp spikes in Libor from September to December last year, as the interest rates at which banks lent to each other climbed markedly above base rates set by central banks (Risk January 2008, pages 74-76).1 Having tracked US interest rates closely - three-month US dollar Libor remained virtually unchanged at 11 basis points over the Fed funds rate for the first eight months of the year - Libor began to disengage in August, as the US subprime mortgage crisis stepped up a gear (see figure 1). By September 7, three-month US dollar Libor was at 48bp over the Fed funds rate, reaching a high of 86bp on December 11.
More troubling for central banks, in the last four months of 2007, a series of interest rate cuts designed largely to coax interbank lending rates down and reinvigorate borrowing between banks appeared to be largely ineffectual, suggesting an unprecedented breakdown in the relationship between Libor and central bank rates.
On December 11, the Fed cut interest rates for the third time since September, decreasing the Fed funds rate by 25bp to 4.25%. However, three-month Libor ended the day virtually unchanged at 5.11% and dropped only 5bp the following day. By the end of the year, the spread between the Fed funds rate and Libor was at 45bp.
The breakdown was even more marked in three-month sterling Libor. On December 5, the BoE cut its base rate by 25bp to 5.5% but Libor didn't flinch, finishing the day at 6.64%, 114bp higher. Over the course of the next week, three-month sterling Libor barely moved until it fell to 6.51% by December 13 and ultimately 5.99% by December 31.
The surge in Libor rates left banks scrabbling around for funding, particularly towards the end of last year. But it also had a knock-on effect on various structured products launched over the past few years - in particular, range accruals referenced to Libor. These products pay an enhanced coupon, so long as Libor remains within a predetermined range during the observation period. (The payout is calculated as the number of days Libor remains within the range, divided by total number of days, multiplied by a leverage factor.) These structures are often callable by the issuer after a certain time.
Range accruals were very much marketed as a way for investors to take a view on the direction of interest rates and central bank policy. And they proved to be a hit among retail, high-net-worth and institutional investors across the globe. "Dollar-based Libor range accruals account for over 50% of the overall US structured note market. We broadly estimate last year's structured note business to be between $40 billion and $60 billion, with over half of that dedicated to range accruals," says Venu Angara, head of US exotics at JP Morgan in New York.
Investing in these structures as a bet on central bank policy seemed entirely reasonable until August last year, given the stable relationship between base rates and Libor. Since then, investors have been exposed to a reference rate driven more by liquidity and credit risk concerns between banks - something much more unpredictable than base rates and little understood by all but the most sophisticated clients.
Dealers say there was some impact, and those range accrual notes with aggressive barriers would not have paid full coupons during the second half of last year. However, they stress most outstanding notes are referenced to US dollar Libor with an upper barrier of 7%. The highest level reached by three-month US dollar Libor last year was 5.725% on September 7 - still some considerable distance below the point where investors would lose their coupon. George Nunn, head of foreign exchange and rate structuring at BNP Paribas in New York, estimates 90% of range accrual notes issued over the past two years would have been structured with 7% barriers, meaning the majority of investors would have been safe during the volatility of 2007.
In fact, Libor has fallen sharply since the turn of the year, reflecting increased liquidity and co-ordinated action by five central banks, announced on December 13, which went some way to easing end-of-year funding concerns. Three-month US dollar Libor had fallen to below 4% by January 15 and was fixed at 3.33% on January 23, a day after the emergency 75bp rate cut by the Fed.
This plunge in Libor rates actually means many of the outstanding range accrual notes are likely to be called by issuers in the coming months, reflecting the enhanced probability these structures will continue to pay high coupons to investors until maturity. "We are going to call Libor-based range accruals when Libor rates fall and the curve steepens, since the probability of breaching the barrier in the next few years would have dropped substantially. Over the past few months, a good portion of Libor-based range accruals issued over the past few years have been called," says Angara.
Similarly, Barclays Capital is likely to call every note it has issued in the past year with a barrier of 6.5% or higher, says Ajay Rajadhyaksha, US head of fixed-income strategy at Barclays Capital in New York.
But will more range accrual notes be launched in their place? The third and fourth quarters of last year hammered home that Libor cannot be assumed to be a proxy for base rates. While investors may be prepared to take a view on the direction of interest rates, they may be less eager to base their investments on the vagaries of liquidity and counterparty credit risk. Retail and high-net-worth investors, in particular, may not be willing to be exposed to this kind of risk.
However, dealers report the majority of interest for these structures over the past few years has come from institutional clients. "We saw $15 billion of range accruals bought by US investors in 2007, but 70-75% of this business occurred in the first half of the year, with around a third going through in the first week of January. The majority of buyers are insurance companies, central banks and investment banks - the kind of investors who are typically yield-sensitive, rather than the likes of hedge funds that are more returns-sensitive," says Rajadhyaksha.
Many professional investors are not overly concerned about the disconnect between Libor and base rates, he claims. For a start, Libor did not get close to the 7% barriers embedded in most structures. Second, the disconnect is reversing - by January 23, three-month US dollar Libor was 17bp below the Fed funds rate, while sterling Libor was nearly 2bp below the BoE's base rate. "One short-term Libor/Fed funds disconnect is nothing for the market to get too concerned about. It has already started to correct itself and no bank, trader, dealer or analyst thinks this is going to be a long-term issue," says Rajadhyaksha.
At the same time, there's little alternative. Banks cannot structure products directly referenced to the Fed funds rate, as there's no way for dealers to hedge directly. One option may be to reference structured products to overnight index swaps, although many think investors may prefer to stick with Libor. "We are able to offer some non-Libor-linked structured products, such as Fed funds-linked notes, but we have some limitations as there is no way to get out of the risk," says BNP Paribas' Nunn. "The beauty of a Libor range accrual is that all the over-the-counter hedging products are Libor-linked from swaps to forwards to options. That means you can risk-manage the position well. In a range accrual on Fed funds, you can only get out of the delta exposure, but can't get rid of the vega and skew."
Nonetheless, the coupons on these structures are now lower than they were in January 2007, which could cause a slowdown in volumes. Indeed, sales of range accrual notes dropped off sharply in the fourth quarter of last year - although that was largely caused by general anxiety among investors about subprime exposures held by banks.
To achieve similar coupon levels, investors could extend the maturity of their investments. "The coupon on three-month US dollar Libor was between 7% and 8% in 2007, but you're looking at between 6.5% and 7% for notes issued today," says Rajadhyaksha. "Given that interest rates have come down so much, the 10-year note, non-callable for one year, is now being extended to a 15-year note. Instead of a 10-year maturity, investors are moving out to 15-year maturities so they can get a similar yield to what they were chasing last year."
The other option is to embed a more aggressive barrier - but investors are less keen to take this route given the volatility of last year, say dealers. "Back in 2003, when the Fed funds rate was at 1%, we saw range accruals set with very aggressive barriers that were just above three-month Libor. They didn't perform at all, and those investors who risked it got zero coupon when those conservative barriers were breached. With rates falling, I think people will be far more cautious about where they set the barriers this time around," says Ralph Sebastian, head of interest rate options trading at Commerzbank in London.
While the actions of Libor may have given some range accrual investors a bit of a scare last year, products linked to constant maturity swap (CMS) spread options have performed strongly. These products pay a leveraged coupon based on the spread between two points on the yield curve - for instance, the 10-year CMS rate minus the two-year CMS rate.
While there are various forms of CMS spread structures, steepeners and range accruals have been among the most popular. The former pays the spread between two CMS spreads, multiplied by a certain leverage ratio. Range accruals, meanwhile, pay a high coupon if the spread between two CMS rates is above a certain level, typically zero. In late 2006 and early 2007, the US dollar yield curve was flat and close to inversion, causing misery for some CMS investors whose fixed-rate period was at an end (these products often pay a fixed-rate coupon for the first year or two).
However, five interest rate cuts since December by the Fed, bringing the Fed funds rate from 5.25% to 3%, has caused the US dollar yield curve to steepen sharply. As a result, CMS range accruals are in vogue once again. "Given that the curve is steepening, I think we will see CMS spread range accruals becoming even more popular, although the drop in interest rates will make coupons a little smaller for those being issued now as opposed to last year," says Angara.
In fact, dealers are generally bullish about the potential for structured interest rate products. Some suggest this year will see more path-dependent products - for instance, dual range accruals linked to CMS and foreign exchange rates, or a return of the inflation capped at Euribor products popular in 2006. Others believe simpler products that draw value from the steepness in the curve will be more popular. While the divergence in Libor and base rates has spooked some investors - and indeed, may encourage some dealers to structure products linked to overnight index swaps - many believe the knock-on effect will be muted, even in range accruals.
"In my experience, we're seeing more interest in range accruals," says Sebastian. "Demand will pick up and the suggestion the ECB will have to cut rates to follow the Fed makes me think business in accruals will only increase."