This article expands on my October private monthly newsletter on LIBOR. Some of you only subscribe to my posts when you should subscribe to both. The private newsletter often has more thoughts on what’s going in the markets at the moment and some personal tidbits. This topic on LIBOR is too important to be kept private.
LIBOR has risen dramatically since the end of 2015. The catalyst was the Fed raising the Fed Funds rate for the first time in years from a target rate of 0% – 0.25% to a target rate of 0.25% – 0.5%. But it’s surprising how LIBOR has risen by almost 1.4% while the Fed has only raised by 0.25%. The last two-month ramp from 1.22% to almost 1.6% is very concerning or is it?
If you are in an adjustable rate mortgage where your initial fixed rate period will go variable within a couple years, you are going to be paying higher rates if you don’t refinance because ARMs are usually tied to LIBOR + a fixed margin.
Below is a snapshot of my mortgage refinance terms from earlier this year. Notice how my 2.375% ARM rate is based off 1 Year LIBOR + a margin of 2.25%. Also observe how the math doesn’t add up: LIBOR at the time was 0.42% + 2.25% margin = 2.67% instead of 2.375%. In other words, lenders subsidize you for the initial 3, 5, 7, 10 year fixed term to win your business.
If my ARM were to float today, my 2.375% mortgage interest would actually jump to around 3.82% (2.25% margin + 1 Year LIBOR 1.57%). Although 3.82% isn’t particularly high in the history of mortgage rates, it’s still 60% higher than what I was paying. Everything is relative in finance.
If you refinance now, you will also re-lock a subsidized rate for your ARM, or simply get a higher, non-subsidized rate with a 30-year fixed mortgage. Check rates online.
Regulatory Changes
So why has the spread between risk free rates and LIBOR widened so dramatically? According to Jeff Rosenberg, Chief Investment Strategist for Fixed Income at BlackRock, rising LIBOR isn’t a signal of credit stresses in the financial sector; instead, rising LIBOR is due to impending regulatory changes to U.S. money market funds (MMFs).
Jeff writes, “The reforms, adopted by the Securities and Exchange Commission in 2014, go into effect Oct. 14 of this year (today!). The new rules will change the structure of money market funds by moving from a fixed $1 net asset value (NAV) to a floating NAV for institutional “prime” money funds, and imposing potential redemption fees and suspensions in the case of some other MMFs.”
As result of the new rule, there’s been a large shift of money market funds out of prime funds and into government funds (prime funds invest primarily in corporate debt securities). “This uncertainty has fund managers increasing liquidity and shortening maturities as Oct. 14 approaches. The result is a decline in the supply of short-term (i.e., three-month) funding in the corporate financing market, and a rise in borrowing costs,” Jeff continues.
Confusing! The bottom line is that once again, thanks to government regulation of the free market, there is another kink in the system.
What Else To Do Besides Refinance?
1) Increase your savings rate. Higher interest rates dampen demand because it makes borrowing money more costly. The more cash you have, the less you need to borrow. The more cash you have, the more you have to lend. Short-term pullbacks are common with risk assets because there needs to be a recalibration of the yield spreads back to its historical range. There is NO RUSH to buy risk assets as a result.
We’ve basically been range bound for the past two years in the S&P 500. It is my belief we will continue to be range bound for the next 12 months.
The iShares Core US Aggregate Bond (AGG) market has also been range bound, although it is retrenching now due to rising interest rates.
2) Research higher income generating assets. As a retiree who paradoxically works his butt off and is therefore in a higher marginal tax bracket, I’m salivating at finally being able to build a sizable municipal bond portfolio that’s state and federal tax free. After buying stocks with a growth bias since the recession, my goal is to now shift the principal gains towards income generating assets as global growth slows.
It’s always important to focus on converting “funny money” into either a real asset that doesn’t go *POOF* in the next recession or a steady income generating asset. I know so many people who were paper millionaires during the 2000 dotcom bust who ended up with NOTHING but a tax bill for assets also worth NOTHING.
Three Investments I’m Looking At
Here’s the Pioneer Municipal High Income Advantage Trust ETF, MAV. It’s close to a 52-week low and is currently spitting out a 7%+ federal tax free yield. It’s also trading at its lowest premium to NAV in five years. The main negative is that it has a 1.2% expense ratio.
Here’s the more conservative iShares National Muni Bond ETF, MUB. It’s currently at a 6 month low and provides a 2.25% yield with only a 0.25% expense ratio. Not as juicy, but not as volatile either. From its 12-month high to its 12-month low, it’s only declined by 3% versus a decline of 9.5% for MAV. I’m also focused on CMF, a California Muni Bond fund so I don’t have to pay state taxes on the income either.
Another idea is the Blackstone Mortgage trust REIT ticker BXMT. Blackstone Mortgage Trust (BXMT) originates and purchases senior mortgage loans collateralized by properties in the U.S. and Europe. It currently offers a ~8.5% dividend yield and should benefit from rising LIBOR given ~78% of its portfolio is indexed to LIBOR and the rest is fixed. BXMT is considered the riskiest of the investments I’ve highlighted, and is not tax free.
If the 10-year bond yield, currently at ~1.78%, hits 2%, I will be aggressively buying various bond funds, REITs, and real estate crowdsourced investments. Just this summer, everybody was talking about potentially negative US interest rates.
As always, do your own research before making an investment decision. Given these are public investments, feel free to provide your thoughts all day long. I’m only looking to grow my net worth by 2 – 3X the risk-free rate of return, or roughly 3.5% – 5% a year because I’ve accumulated my target nut already. There’s nothing I dread more than losing money because that increases my risk of having to go back to work full-time!
If you’re looking for a low cost solution to build a diversified municipal bond portfolio or multi-asset portfolio of up to 30 names for only $9.95, check out Motif Investing. It’s better to hold tax advantageous assets in taxable accounts, otherwise there’s no point.
3) Boost your Certainty Income. Because we are in a political and interest rate transition period, we have uncertainty. When there is this much uncertainty, investments tend to go nowhere. Therefore, it’s only logical to boost your “Certainty Income” through additional effort.
Now is the time to take that second job or add on another consulting client. Now is the time to launch your website to grow your personal brand. Build your book of business today for the potential fade. And if things turn out just fine in 2017, then you’ll simply have an extra income rocket booster by your side.
I’m finishing up a 3-month consulting contract with an SF-based insurance company this month, in the interview process with a health tech startup, sat down with the CFO and CMO of a potential partnership/acquisition last week, and just got back from a 1.5 day paid gig in Seattle with a large financial institution. Oh yeah, and then there’s publishing on Financial Samurai 3X a week, baby! Always be hustling and looking ahead for new opportunities.
If 20% – 39% of your total income can come from active income, I think this is ideal.
Bullish Or Bearish Doesn’t Matter
Rising LIBOR is a short-term negative, but likely a long-term positive. There cannot be sustained higher rates if there isn’t a sustained higher demand for money. If the demand for money fades, so will LIBOR. Not only is everything relative in finance, everything is also rational in the long run as well.
It’s always nice when your investments act as a tailwind for net worth growth. Just know that it’s even nicer if you can build enough income streams so you aren’t reliant on your investments at all. Besides, active income is more enjoyable than passive income. Sitting back and collecting the digital Benjamins is not really fun or rewarding. Going out there and doing work that’s meaningful while earning is.
Related: Recommended Net Worth Allocation By Age Or Work Experience
Readers, did you know that LIBOR is on fire? What are you doing in light of rising LIBOR? Should we look to invest in financial institutions or REITs that benefit from LIBOR?
from Financial Samurai http://www.financialsamurai.com/rising-libor/
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