In the current interest-rate environment, our customers’ margins are being squeezed—more and more everyday—and the all-important “net interest spread” is harder and harder to come by. Since margins are the key driver of financial performance for most financial institutions, it’s no wonder to us that our customers are working diligently to maintain their margins—by improving their yields on earning assets and/or reducing the cost of interest bearing liabilities.

Here on the funding desk, we can offer some great ideas to help with the funding side of your business. Because most of you are familiar with the array of funding products offered by the Seattle Bank, we won’t present the intricacies of all our products in this article. Instead, we’ll focus on one of our more underused funding products: the amortizing advance.

The amortizing advance sees little use relative to our other advance products. As a proportion of our advance portfolio, amortizing advances make up about 5%. When properly applied, however, it is one of the more dynamic and useful advance products we offer.

The Product
The amortizing advance is a fixed-rate advance with a predetermined schedule of principal cash flows that must be paid over the life of the advance—and that is exactly what gives this advance its advantage. Before we look at some examples of how you might use this advance product, however, let’s discuss its mechanics.

There are basically two types of amortizing advances. They differ based on how their cash flow payments are structured. The “straight-line” advance, as the name implies, amortizes the principal in equal payments due each month during the life of the advance. (Interest is also due monthly.) For example, an advance with a four-year final maturity, amortized using the straight-line method, will have a weighted average life of two years.

The “customized” amortizing advance basically encompasses all the structures that don’t fall into the straight-line category. These can range from an advance with a level-pay amortization schedule, to an advance with a lockout period followed by a schedule of principal payments. The flexibility in structure is one of the most important benefits of the amortizing advance. Unfortunately, it is also one of the most overlooked.

Match Funding
One key way to take advantage of the product’s flexibility is to use it to match-fund, or hedge, asset transactions. Here’s an example.

Let’s say you’re making a loan to a customer, and you want to hedge the transaction by matching it with a liability with similar cash flows. If your customer is looking to take down a five-year, fully amortizing commercial loan, you are not going to fund the asset with a five-year liability. Why? A five-year commercial loan has a duration somewhere close to four years. In this case, a customized amortizing advance can be created to closely match the cash flows of the loan, thus providing a good duration-match for the asset. After all, it’s not the final maturities that are important to match; it’s the duration of the asset and the liability that you need to focus on.

Let’s look another example. Assume your customer is looking for a commercial loan with an amortization schedule of 20 years and a balloon payment at the end of the fifth year. You want to match fund this loan through the Seattle Bank, but can’t find an advance to match the term. In this case, we can create a customized amortizing advance with an amortization period of 20 years and a final maturity of five years. The advance structure will closely match the duration of the loan, thus providing a good funding vehicle, assuming match funding is the strategy you choose.

Duration and the Current Yield Curve
As we all know, duration represents a measure of the present values of cash flows, weighted by their term. An amortizing advance will always have a shorter duration than a bullet advance. The reason for this, of course, is the occurrence of principal cash flows over the term of the amortizing advance. In the current flat yield-curve environment, the decision to use amortizing advances can be muddled by comparing them to bullet advances.

Consider a five-year bullet advance and a five-year customized (level pay) amortizing advance. Due to the flatness in the yield curve, these two advance rates provide the borrower with similar interest rates on their borrowings. For example, the five-year bullet priced around 4.48%, while the five-year, level-pay amortizing advance priced at a rate of 4.55%. At the same time, these two advance products provide the borrower with dissimilar durations (again, the bullet will have a longer duration). Why would you pay a similar rate for a liability with less duration?

The answer lies in the structure of the product. If a borrower is strictly out to buy duration, then the bullet structure is obviously the way to go. But, with the possibility of an inverted yield curve on the horizon, is extending the duration of your liabilities a priority? Also, remember that advance values do not behave like fixed-income investments when “rolling down the curve.” With the bond market ever harder to predict, extending the duration of term borrowings may not be your priority—even though your instinct tells you interest rates are going up. The shorter-duration advance with cash flows may bear some consideration in this environment.

¹ A small factor in the current similarity in rates is the fact the Seattle Bank adds on a small amount of extra spread to amortizing advances due to higher hedging costs.
² “Rolling Down the Curve” is commonly used to refer to a fixed income security’s property of increasing in market value as time passes (assuming a positively sloped yield curve). Note this occurs up to a certain point until market value will peak due to the shortening of the remaining term to maturity.

Figure 1. Changes in Yield Spreads (%)

Filling a Gap
Another way to use an amortizing advance is to manage predicted deposit runoff and/or gathering to increase your liability sensitivity. Let’s say your bank is planning to end one of your deposit specials next week. After extensive analysis of deposit elasticity, management is forecasting a $1-million runoff due to rate-sensitive customers moving their funds. Although you’re not planning to run any specials to attempt to retain those deposits, you do plan on implementing an aggressive deposit-gathering strategy 12 months from now to support bank growth.

In this situation, an amortizing advance can help in two ways: (1) to fill the funding void left by the deposits, and (2) to fund the current growth of your bank, while maintaining the flexibility to replace the advance with deposits in the future.

Continuing with the example, let’s assume your bank takes down a $2-million, four-year, customized amortizing advance with the first payment occurring in one-year and with equal monthly principal payments thereafter. The $2 million replaces the $1-million void left by the deposit runoff, as well as providing $1 million of additional funding. Your strategy is to replace this wholesale funding with lower cost deposits over the next several years. The fact that the advance amortizes over three years allows you to replace the wholesale funding with lower cost deposits incrementally, over time.

Figure 2. Temporary Funding (Composition of $2mm in Funding)

Amortizing advances can play an important role in funding your balance strategies—from general funding to match funding of assets. The standard pricing for straight-line amortizing advances appears every morning in the Daily Rate Sheet provided by the Seattle Bank’s Customer Funding department. If there’s a specific structure you’d like to have priced, please give us a call at 800.340.3452. We’ll be happy to help.

For more information, please contact Erick Rendon at the Seattle Bank.

IMPORTANT DISCLAIMER, PLEASE READ: The Federal Home Loan Bank of Seattle ("Seattle Bank") publishes What Counts for educational and promotional purposes only. The data and analysis presented are based upon information obtained from sources that we consider reliable. The opinions expressed represent the current opinions of our staff and are subject to change without notice. We make no warranties, express or implied, regarding the accuracy or completeness of any information, analysis, or opinions presented. No part of this newsletter may be reproduced in any manner without the written permission of the Seattle Bank. The Seattle Bank, its employees, agents, and contractors are not registered investment advisors, financial advisors, or broker dealers, and they are not acting in a fiduciary capacity. The information contained in this newsletter does not constitute a recommendation, offer to sell, or solicitation of an offer to purchase any particular investments or products, including without limitation securities of any companies discussed, and it should not be construed as such. It is the reader’s responsibility to evaluate the suitability, risks, and merits of any investment, funding strategy, or business proposal presented in this newsletter. Newsletter content is for our readers' informational purposes only. Please refer to our Terms of Use for details.