What does the LIBOR-OIS spread tell us that the TED spread doesn't?

Question

AcadiFi · Accepted Answer

The LIBOR-OIS spread is a more refined measure of banking stress than the TED spread, and understanding why requires knowing what the OIS rate represents.

**Definitions:**
- **TED Spread** = LIBOR - T-bill yield
- **LIBOR-OIS Spread** = LIBOR - Overnight Index Swap rate

**What is the OIS Rate?**
The Overnight Index Swap (OIS) rate reflects the market's expectation for the average overnight rate (e.g., Fed Funds rate or SOFR) over the swap's term. It has essentially zero credit risk because:
- It's based on overnight lending (principal returned each day)
- Overnight bank default probability is negligible
- No principal is exchanged in the swap itself

**Why LIBOR-OIS Is Cleaner Than TED:**

The TED spread mixes two different things:
1. Bank credit risk (LIBOR side)
2. Demand for safe-haven T-bills (T-bill side)

During a crisis, T-bill yields fall sharply due to flight-to-quality, which inflates the TED spread even beyond the actual increase in bank risk.

The LIBOR-OIS spread removes this distortion. The OIS rate only reflects expected monetary policy, not safe-haven demand. So the LIBOR-OIS spread isolates pure bank credit/liquidity risk.

| Indicator | What It Measures | Distortions |
|-----------|-----------------|-------------|
| TED Spread | Bank risk + flight-to-quality | T-bill scarcity inflates spread |
| LIBOR-OIS | Pure bank funding stress | Cleaner signal |

**Historical Comparison:**

During the 2008 financial crisis:
- TED spread peaked at ~460 bps
- LIBOR-OIS spread peaked at ~365 bps
- The ~95 bps difference was entirely due to T-bill scarcity (flight-to-quality)

**Post-LIBOR World:**
With LIBOR's discontinuation, the equivalent spreads are:
- **SOFR-OIS spread** (or term SOFR vs. OIS)
- **BSBY-OIS spread** (Bloomberg Short-Term Bank Yield Index)
- The concept remains identical — interbank term rate minus expected overnight rates

**Example:** In a hypothetical March 2026 stress event:
- 3-month SOFR: 4.85%
- 3-month OIS rate: 4.50%
- 3-month T-bill: 4.10%

LIBOR-OIS equivalent: 35 bps (moderate stress)
TED equivalent: 75 bps (looks worse because of T-bill scarcity)

The LIBOR-OIS spread of 35 bps more accurately reflects actual bank funding pressure.

**Exam Tip:** Be able to explain why LIBOR-OIS is a purer measure of bank credit risk than TED, identify that the difference between the two spreads reflects flight-to-quality demand for T-bills, and know the post-LIBOR equivalents.

Study credit market indicators in our CFA Level II fixed income course.

What does the LIBOR-OIS spread tell us that the TED spread doesn't?

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