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Toughing Out a Flatter Yield Curve
Increasing Earnings and Decreasing
Balance Sheet Sensitivity via Structured Investment and Funding Solutions
“Following the light of the sun, we left the Old World.” – Christopher
Columbus
No doubt about it. As the yield curve continues to flatten, it’s
becoming increasingly difficult to generate returns. Consider the swap
curve on the basis of today’s rates, juxtaposed with implied forward
rates one and five years from now. As Figure 1 implies, it’s no
longer easy to fund at shorter durations and invest at longer durations.
Moreover, the implied forward yield curve projects even further flattening.
Figure 1. Current vs. Implied Forward Yield Curves
Nonetheless, as Figure 2 demonstrates, yield volatility has been on
a steady decline over the past year. This could imply that the value
of options embedded within callable investments could be a source of
incremental yield.
Figure 2. Historical 10-, 30-, 50-, 100-Week Yield Volatility: 2-Year
Treasury
If you can acquire evidence (using appropriate financial modeling tools
and processes) that your balance sheet is positioned to hedge potential
investment strategies, there are some interesting approaches to consider.
For example, if you find yourself in a projected asset-sensitive position,
you could consider asset strategies that boost yield, yet may under perform
in the event interest rates rise—only to be mitigated by our asset-sensitive
balance sheet. You might also have a natural balance sheet hedge if you
carry a position in agency “step-up” investments. Why? Defensively
structured step-ups bear coupons that are initially set below market,
in exchange for coupons that increase at prescribed levels (assuming
they are not called in a rising rate environment).
In this month’s issue of What Counts, we highlight two specific
investment and funding strategies that are best tailored for neutral-to-asset-sensitive
financial institutions.
Structured Investment/Funding Strategy #1: Floating-Rate Investment
First,
we’ll consider a strategy that incorporates short-term,
variable-rate funding, derived from 91-day Auction Advances from the
Seattle Bank. The funding is invested in a structured range note with
the following characteristics:
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Issuer: Seattle Bank |
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Coupon: LIBOR + 2.00%, subject to 3-month LIBOR not exceeding pre-specified
levels (see Figure 4) |
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Minimum Coupon: 3.00% |
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Call Structure: Every 3 months |
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Maturity: 10 Years |
Figure 3. Floating-Rate Structured Investment/Funding Strategy
Next, we’ll look at the relationship between the permitted ceilings
on LIBOR and the implied forward rate for each point on the yield curve.
Figure 4 demonstrates that the LIBOR range ceiling never exceeds implied
forward rates, and the spread between the two variables widens over time.
Figure 4. Structural Details: Seattle Bank Indexed Floating Rate Note
Index Formula: Coupon = LIBOR + 2.00%, subject to 3-month LIBOR
not exceeding levels specified below. Minimum Coupon = 3.00%
Time Period |
Level LIBOR Not Permitted to Exceed vs.
3-Month LIBOR Forward Curve |
Year 1 |
4.25% / 3.90% |
Year 2 |
4.76% / 4.16% |
Year 3 |
5.15% / 4.33% |
Year 4 |
5.65% / 4.48% |
Year 5 |
6.15% / 4.70% |
Year 6 |
6.65% / 4.71% |
Year 7 – 10 |
7.00% / 5.32% |
About Auction-Based Advances
The Seattle Bank’s
Auction-Based Advances are fixed-rate products that offer
short-term funding at highly competitive rates. They are often
the Seattle Bank’s most attractive funding source—often
four to eight basis points lower than other Fixed-Rate Advances
with comparable maturities. The notes are available in fixed
terms of 28, 63, 91, and 182 days. The fact that maturities
are set at seven-day intervals allows the member to re-fund
one maturing Auction-Based Advances with another.
The Auction-Based Advances are funded through the FHLBank
Office of Finance’s twice-weekly auction of short-term
consolidated obligations, also known as discount notes. As
such, the advance is offered twice a week, on Tuesdays and
Thursdays (orders must be received by 8 a.m. PST). Advance
proceeds are available the following day (i.e., on Wednesdays
and Fridays). On the day of the auction, the Office of Finance
pools the orders from the 12 FHLBanks for each one of the
maturity dates. Once the orders are aggregated, investors
bid on the discount notes, and the appropriate interest rate
is determined for each maturity.
Unlike a standard advance, the Auction-Based Advance rate
is not guaranteed when a member places the order. The Seattle
Bank attempts to provide its members with accurate indicative
rates for each maturity, but the interest rates on the advance
are determined by the auction results. Thus, the member bears
the risk that the actual rate on the advance may vary from
the indication. Also, in the event there are insufficient
orders for a specific structure, the auction for that structure
might not take place. In this case, the Customer Funding department
would attempt to contact the member prior to the deadline
to discuss alternatives.
Auction-Based Advances require a minimum order of $100,000.
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Figure 5 demonstrates projected spreads under several gradual rate-increase
scenarios. In scenarios involving unchanged rates and gradual rate increases
of 100 and 200 basis points, a projected spread of 2.07% is maintained.
When rates increase by 300 basis points over a three-year time frame,
the interest spread is –1.34% during the third year, but still
averages 0.93% during the entire three-year period. Assuming rates held
flat after the increase, the higher ceiling would push the spread back
into positive territory by the fifth year. However, the likelihood is
that the note would be called.
Figure 5. ROA: Floating-Rate Structured Investment/Funding Strategy
As a final step, you would assess the ability of your balance sheet
to act as a natural hedge in the event you employed this liability-sensitive
strategy during a period of rising rates. Figure 6 summarizes sample
output of a dynamic balance sheet simulation that the Seattle Bank’s
Financial Advisory Services team can produce on behalf of members that
participate in consultative workshops and/or subscribe to Interest Rate
Risk Services.
Figure 6. Representative Output – Dynamic
Balance Sheet Simulation
| |
-100 bps |
+0 bps |
+100 bps |
+300 bps |
“Bear
Flattener”
Scenario |
| Average Net Income |
$1.812m |
$1.576m |
$1.718m |
$2.098m |
$1.597m |
| Average ROA |
1.40% |
1.19% |
1.30% |
1.59% |
1.17% |
| Average ROE |
14.63% |
13.11% |
14.05% |
16.82% |
13.19% |
| Ending Capital/Assets |
10.15% |
9.66% |
9.84% |
10.59% |
9.62% |
| Asset Growth |
17.2% |
17.2% |
17.8% |
18.0% |
17.8% |
| Loan Growth |
23.0% |
23.9% |
24.3% |
24.4% |
24.2% |
| Deposit Growth |
8.0% |
8.0% |
8.0% |
8.0% |
8.0% |
Our representative institution
clearly shows some asset-sensitive characteristics that would offset
the deleterious effect of rising rates upon the floating
rate indexed note. As we’ve underscored in previous issues, an
optimal analysis would include the pro-forma modeling of the entire balance
sheet that incorporates the proposed investment on the balance sheet.
Structured Investment/Funding Strategy #2: Fixed Rates
Our second strategy includes a blend of overnight, two-year bullet and
three-and-a-half year advances directed toward the purchase of an agency
step-up bond and a 5/1 hybrid, adjustable-rate, mortgage-backed security.
Investment characteristics are highlighted in Figure 7.
Figure 7. Floating-Rate Structured Investment/Funding
Strategy – Fixed
Rate Investments
With an investment duration of 1.42 and a funding duration of 1.03,
intuitively, this strategy would bear liability-sensitive characteristics.
Indeed, when we model the projected spreads over a five-year timeframe,
we see that the strategy performs best under a flat rate, or –100
basis points scenario, with projected average lifetime spreads of 1.75%
and 1.67%, respectively. If rates increase 300 basis points, we see the
spread drop to five basis points in the second year. Throughout the five-year
period, under a +300 basis points scenario, spreads still remain positive.
Under this scenario, if your balance sheet is identified as asset-sensitive
and can act as a natural hedge, so much the better.
Figure 8. Projected ROA: Floating-Rate Structured
Investment/Funding Strategy – Fixed Rate Investments
About Bullet and Amortizing Advances
Bullet advances are simply fixed-rate advances with interest
paid monthly and principal due at maturity. They can range
from 7 days to 30 years in maturity. Bullet advances can help
you efficiently meet short-term funding needs, supplement
retail deposits, and manage the risk associated with shorter-term,
rate-sensitive investment and lending activities. Long-term
fixed-rate advances can accommodate a range of asset/liability
management needs and allow you to more effectively manage
the risks associated with your long-term portfolios. The minimum
dollar amount for a fixed-rate bullet advance is $100,000.Amortizing
advances allow you to reduce the principal level of your liabilities
in tandem with the assets funded.
The amortizing advance is a fixed-rate, fixed-term advance
with principal repaid over the term of the advance. Principal
and interest payments are payable monthly on the first business
day of each month with the final principal payment payable
on maturity. Amortizing advances may be customized with the
principal payable on a schedule other than monthly (i.e.,
quarterly, semi-annually, or annually). Unless otherwise requested
at the time of borrowing, the Seattle Bank assumes straight-line
amortization for these structures.
For example, a customer taking down a $6.0 million, five-year
straight-line amortizing advance will have 60 monthly principal
payments of $100,000. Alternatively, the member could request
a customized amortization schedule, or what is commonly referred
to as a level-pay schedule. With level payment amortization,
the member would have 60 equal payments of principal and interest.
Amortizing advances can be further tailored to match specific
member needs, including balloon payment structures (e.g.,
20-year amortization schedule with a 7-year balloon).Both
the bullet and amortizing advance structures may be prepaid
prior to maturity, subject to the Seattle Bank’s prepayment
fee calculation. Fixed-rate advances may be prepaid in whole
or in part.
Amortizing advances must be prepaid in entirety, The prepayment
fee is calculated on a yield maintenance basis intended to
render the Seattle Bank financially indifferent to the borrower’s
decision to repay the advance prior to its maturity date (For
further details on prepayment fees please refer to the Financial
Products and Services Guide.)
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“A Whole New World…”
The move to a flatter yield curve has occurred rapidly (over the past
eight months), and is a direct result of six consecutive moves by the
Fed. More are likely to come. As such, the period from 2001 – 2003
that brought the steepest yield curve in over 40 years can no longer
be relied upon as a source of yield arbitrage. In order to fight the
permanent headwinds of declining margins, financial institutions must
increasingly look to other sources of yield, including optionality, credit
complexity, and structured funding applications. If you deploy the right
tools and continually model and monitor your interest-rate sensitivity
while you develop funding and investing strategies, you’ll hold
a competitive advantage in this whole new world.
John Biestman is assistant vice president, IMS consultative
sales advisor, and Erick Rendon is
business development analyst at the Federal Home Loan Bank of Seattle.
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