Strategies
The Knockout Putable Advance: Set it and forget it!
July/August 2008
“If you must play, decide upon three things at the start: the rules of the game, the stakes, and the quitting time.” ~Chinese Proverb
During these hectic days of credit turmoil, nobody needs any extra aggravation—particularly when you can simplify your funding needs and do so at attractive levels. With the expectation of rising rates, the Seattle Bank has offered a number of Capped Floater Advance structures in recent weeks. The Capped Floaters have enabled Seattle Bank members to purchase interest-rate caps on specified floating-rate indexes and blend the caps with floating-rate funding to mitigate a rise in rates.
To complement these “long-option”1 advances, we also offer “short-option” structures like the Knockout Putable Advance. This is a putable advance that can be “put” back to the borrower if a specified floating-rate reference index (i.e., three-month LIBOR) reaches a certain level.
A Knockout Putable Advance is a simpler version of a putable, with less refunding risk. It’s simpler because you do not have to gauge the shape of the forward swap curve or monitor shifts in the direction of forward rates to determine potential termination dates. You simply track the absolute level of three-month LIBOR, and pencil in the strike rate that terminates the funding. In this regard, you can think of the Knockout Putable Advance as a “set it and forget it” structure.
The Knockout Putable Advance also contains less refunding risk, because the borrower can predict calls on absolute levels of three-month LIBOR, rather than having to interpret years of forward rate projections. The greater transparency of the optionality is reflected in slightly higher rates than comparable putable structures.
Let’s briefly review the framework for the Knockout Putable structure.
“The Rules of the Game”
Putable advances offer lower all-in advance rates relative to no-option bullets, as putable advance borrowers “sell” interest-rate options and receive payment in the form of a lower advance rate. When selling options, it’s important to keep in mind that just when the value of the options is worth the most to you, you do not have the ability to realize the inherent value. When you want to keep the funding, it is put back to you, and when you want to terminate the funding, it extends. Figure 1 illustrates the behavior of the putable advance.
Figure 1: Putable Advance Mechanics2
|
Putable Behavior |
Effective Term |
Advance Value |
|
Rate Decline |
Extension Risk |
Equity Value |
|
Rate Rise |
Refunding Risk |
Equity Value |
To make educated decisions on likely funding termination dates, it’s important to understand the value determinants of knockout funding.
Knockout funding is very similar to putable funding. Like putable borrowers, knockout borrowers receive fixed-rate funding at a discounted level relative to fixed-rate/no-option bullet funding, in exchange for selling interest-rate options. With knockout funding, however, the expected termination date of the funding is based on a short-term, floating-rate index instead of the shape of the current and future term swap curve. This simplifies the targeting of potential termination dates, as borrowers need not concern themselves with both the shape and direction of rates, but can focus solely on the direction of short-term rates. Generally speaking, one can summarize the Knockout Putable Advance value proposition utilizing Figure 2 below.
Figure 2: Knockout Putable Advance Value Definition
| Market Conditions | Advance Rate | Explanation |
| Long Lockouts | Higher | Longer certainty of funding |
| Short Lockouts | Lower | Shorter certainty of funding |
| Flat Curve | Higher | Lower Volatility, less carry risk |
| Steep Curve- Positive Slope | Lower | High Volatility, more carry risk |
| High Knockout Rate | Higher | Less likely to hit strike rate |
| Low Knockout Rate | Lower | More likely to hit strike rate |
| Low Volatility | Higher | Lower Premium value for sold options |
| High Volatility | Lower | Higher Premium value for sold options |
The lowest relative Knockout Putable Advance rates—and most significant interest rate stance—occur when you sell as many options as possible (short lockout periods), target low LIBOR knockout rates, and sell the options into a market that expects both higher volatility and a steeper forward swap curve. Should you be interested in taking some risk off the table, you can structure the advance with longer-term lockouts, higher LIBOR knockout rates, which all else being equal will result higher advance rates.
Let’s work through an example of a Knockout Putable Advance.
“The Stakes”
Consider, for example, the structure shown in Figure 3, which has a contractual maturity of five years with a one-year lockout period. This means that the advance term could be as long as five years or as short as one year. The reference index is three-month LIBOR, and should three-month LIBOR reach 6.00% on any of the quarterly knockout dates on or after the initial lockout period, the funding would terminate. This evaluation would continue on a quarterly basis, until either the funding is put back to the borrower or the advance matures.
Figure 3: Knockout Putable Advance Example
| Structure: 5-year, non-knockout 1 year (Bermudan) |
| Index | 3-Month LIBOR |
| Knockout Rate | 6.00% |
| Rate | 3.91% |
Now, let’s get to the point: What is the relative value of knockout putable funding, and does it make sense right now?
“Quitting Time”
As shown in Figure 4, knockouts currently offer a significant rate benefit relative to alternative funding structures: their indicative rates are 45 basis points cheaper per annum compared to three-year bullets and 91 basis points cheaper compared to five-year bullets. This makes sense because you are selling interest rate options—four years or 16 quarters worth in this example. Relative to a straight five-year, non-put one year (Bermudan), the knockout structure is 76 basis points more expensive. This, too, makes sense because you are making a more significant “rate play” on the five-year, non-put one year (Bermudan).
Figure 4: Comparison of Alternative Funding Structures
| Structure | Advance Rate |
| 5-year, non-knockout 1year (Bermudan) w/ 6.00% strike rate | 3.91% |
| 5-year, non-put 1 year (Bermudan) | 3.15% |
| 3-year bullet | 4.36% |
| 5-year bullet | 4.82% |
*Indications as of July 22, 2008*
So, what is the relative value of a Knockout Putable Advance? Figure 5 provides the following information:
- Three-month forward rates are not expected to be near 6.00% one year from now. In
fact, based on expectations, three-month levels will not reach 6.00% anytime soon.
The last time three-month LIBOR was trading above 6.00% was in December of 2000.3
- Four-year swap rates are expected to reach approximately 4.80% in one year, suggesting
that the straight five-year, non-put one year (Bermudan) at 3.15% is approximately
165 basis points “in the money” at that point, implying a high likelihood of the
structure being called one year from now and subjecting borrowers to refunding risk.
- Fixed-rate three-year and five-year bullet funding, one year from now, is expected
to be modestly higher than current levels, suggesting that locking in current term
funding may be appropriate.
Figure 5: Forward Rate Expectations
In this example, with the Knockout Putable Advance, you are basically positioning your balance sheet for rising rates across the curve, but assuming that short-term (three-month LIBOR) rates will not rise above 6.00% in the next five years. In addition, you are taking advantage of the current expected point spread of extending longer-term funding, versus rolling short, over a five-year time period. With current fed funds futures suggesting a 12% chance of a target rate of 3.25% and 26% of a 3.00% target by April 2009, term funding may be an attractive funding vehicle. Two questions you have to ask yourself:
- “Can I live with a 3.91% rate for five years?”
- “Will 3-month LIBOR reach 6.00%?”
Evidence supporting the use of Knockout Putable Advance:
- Today, five-year funding costs 4.82% and five-year swap rates one year forward are +35 basis points to current levels. If you need up to five-year funding at 3.91%—91 basis points cheaper than five-year bullet funding—now may be the time to act.
- Expectations for three-month term funding levels one year forward are approximately 3.68%. Based on current expectations, three-month LIBOR will not reach 6.00% over the next five years. Basically short-term rates are expected to rise, but within a defined range.
The decision to fund your balance sheet must take into account numerous financial objectives and myriad theoretical assumptions. The best you can do is to prudently navigate with the information you have today. If structured funding makes sense for your institution, given your balance sheet composition and funding needs, knockout funding could fill both a tactical and strategic funding void—and at a lower all-in relative cost.
Now you know the rules of the game, and we have evaluated the stakes. What’s your next step? Call the Seattle Bank to learn more about the funding options your cooperative offers and how they can work for your institution. The ball is in your court!
The Seattle Bank offers a number of prepayable advance structures, designed to meet
our members’ current funding needs. Visit the
Rates page for currently available structures.
1 Long option refers to the purchased cap, as the buyer is long the cap position because they have purchased it.
2 Extension risk refers to the risk that funding terms will extend if market levels decline. Refunding risk refers to risk that refinancing will occur at higher-than-current market levels. Equity value refers to the value of a financial institution’s equity relative to the value of the advance. When rates decline, equity value declines because the advance value is higher than current levels. When rates rise, the equity value increases because the advance value is lower than current levels, but the value is restricted as the advance may be put back to the borrower.
3 Disclaimer: Forward rates are not accurate predictors of future spot rates.
By Brett L.A. Manning, CFA, Financial Strategist at the Federal Home Loan Bank of Seattle.