Even though the implied forward yield curve remains flat, the Fed continues to telegraph further rate increases. While not a traditionally opportune environment, this situation does offer the opportunity to increase your current income and mitigate the potential effect of rising rates—if you’re willing to extend your liability duration and accept some option risk.

To illustrate the concept in the context of current market conditions, let’s assume that you presently hold a $10-million, Seattle Bank bullet advance with two years remaining on the term. Further assume that the rate on the bullet advance is 4.86%, and it is valued “at-the-money.” Now, assume that we’ll swap the fixed-rate bullet advance into a three-month, LIBOR-based, floating-rate advance as illustrated in Figure 1:

Figure 1. Swap of Fixed-Rate Bullet Advance to Floating Rate

As a result of the initial swap of the fixed-rate bullet advance into a floating-rate obligation, you would realize an initial savings of 63 basis points (4.86% – 4.23%).

Next, the existing funding, now on a variable-rate basis, would be exchanged for a fixed-rate, 10-year maturity/two-year non-put convertible advance. (We’ll assume that the existing funding was at-the-money and not subject to a prepayment fee.) The new advance will support a European option structure, in which the put option can be exercised on a one-time basis (i.e., two years from now).

Figure 2. Refinance of Floating-Rate Funding to 10-Year/Non-Put 2-Year, Convertible Advance

As a result of refinancing the floating-rate advance into the higher-coupon putable advance, there is dilution of the aforementioned savings of 11 basis points (4.23% (LIBOR) – 4.34% (Putable Advance).

Here are the advantages of the “out with the old, in with the new” strategy:

1. With the implied forward rate curve forecasting further short-term rate increases, you may wish to boost asset sensitivity. Extending the duration of your liabilities is one way to accomplish this. In this example, you have increased the initial duration on the liability from approximately 2.0 years to 2.5 years. Duration notwithstanding, it is important to realize the negative convexity associated with the optionality of a convertible advance. As an example, Table 1 depicts a simulated market value of a 10-year/non-put 2-year advance against a range of rate shocks:
   
   Table 1. Representative Simulated Market Value of a 10-Year/Non-Put 2-Year Advance Under a Range of Rate Shocks (From the Perspective of the Issuer – European Settlement)
   

   Rate Shock/	-300 bps	-200 bps	-100 bps	0	+100 bps	+200 bps	+300 bps
   Simulated Market Value	119.6403	110.5638	104.0735	100.0000	97.5605	95.5415	93.7198

   
   
2. You have not increased your exposure to potentially rising rates because the non-putable period is identical to the remaining maturity of the original bullet advance.
   
   
3. Over a two-year period, you would save 52 basis points per year in funding costs.

In effect, the 10-year/non-put 2-year advance is nothing more than the combination of a
two-year bullet advance with the sale of the right to extend the funding by eight years. In this example, the extension option that you are effectively selling is worth 52 basis points annually, over a two-year period. In two years, if the cost of funding for an additional eight years exceeded the coupon rate of 4.34%, the likelihood of the lender electing to extend the advance diminishes. The implied forward rate curve now indicates the eight-year cost of funds to be 5.15%, two years from now. As such, rates would have to drop by 81 basis points (5.15% – 4.34%) before the probability of extending the advance became a significant threat.

In the event the eight-year rate, two years from now, became less than 4.34%, it is likely that the advance provider would extend the borrowing by eight years. As such, if the market rate of borrowing were to be less than 4.34%, margins would be impacted by the difference. For example, a market rate of funding of 4.15% two years from now would result in an annual 48-basis-point deficit over eight years. The net deficit of 0.48% would incorporate the 1.52% loss incurred over eight years, plus the 1.04% gain posted over the initial two years.

*((4.86-4.34)*2) + ((3.15-4.34)*8) = –8.48
**Represents current cost of 8-year funding, two years from now.
***((4.86 – 4.34)*2)

The above analysis indicates that the cost of eight-year funds, two years from now, must be 81 basis points or more below the current expected level of 5.15%, or 4.34%, before the 104 basis points in the two-year coupon advantage begin to erode. If the cost of eight-year funds drops more than 94 basis points, any advantage gained from the initial two years of coupon advantage will be wiped out.

So, here’s the $64 question that only you can answer: In two years’ time, will the cost of eight-year money be 4.21%, or higher? Today, per the swap curve, the cost of eight-year money is 5.05%.

Indications of current levels are posted below, in Tables 3 and 4.

If longer liability duration is not a pressing concern, you might consider the additional yield that you would generally receive on an advance with options structured on a Bermuda basis (i.e., every three months after the initial put date, two years hence). As noted in Tables 5 and 6, the option value (translated into the form of a lower coupon) would be higher because you would run the risk of rising funding costs at more frequent intervals during the remaining eight-year period.

In a flat yield curve environment, it’s undoubtedly getting tougher to sustain your interest margins via the left-hand side of the balance sheet. The last time the yield curve was this flat was during the third quarter of 2000. This was also a point in time when: (a) the Fed was not telegraphing further short-term rate hikes, and (b) as Figure 1 illustrates below, absolute rate levels were far higher that they presently are—implying that five years ago, there was more room for rates to fall.

When it comes to putable advances, the Seattle Bank can help you conduct a similar scenario analysis of different maturities, lock-out periods, and settlement structures. In assessing the role of putable advances for your balance sheet, consider the following:

• First, appreciate the fact that longer lock-outs, shorter maturities, and less-frequent option settlement dates are associated with reduced optionality and, therefore, less yield advantage.
• Second, from a borrower’s perspective, putable advances bear negatively convex, asset-sensitive qualities. That is, from the perspective of a borrower, their market values typically increase as rates increase and decrease at a faster rate when rates decline.

Still, given the historical flatness of the yield curve and the forward market’s continued outlook for rising short-term rates, relative to other non-option sources of funding, the favorable initial yields provided by a putable advance during the lock-out period could play a key role in protecting your interest margin.

John Biestman is assistant vice president, senior financial strategist at the Federal Home Loan Bank of Seattle.

For more information regarding putable advance structures, 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.