The Knockout Putable Advance: "Set it and forget it!"
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. But here’s the dilemma: Do you roll your funding short and take advantage of historically low short-term rates, or do you take some funding risk off the table and extend out the curve, again at historically low levels?
It’s a classic quandary. How do you address the potential opportunity costs and assymetrical pay-offs associated with short-term benefits versus long-term gains? Consider the Knockout Putable Advance,
which addresses both short- and long-term risks—with margin enhancing results.
The current low-rate environment notwithstanding, some worry that, over the longer-term, growth in both Treasury and Federal Reserve balance sheets will spur inflation. If your balance sheet is liability sensitive (and with rates this low, many financial institutions'
balance sheets are), you might want to consider reducing your liability sensitivity as part of your interest rate risk planning.
A sound liquidity policy will take into account both short-term gains and long-term benefits, while managing
an institution's funding in the context of its liability portfolio. Liability allocation must consider a number of risks, including liquidity, refunding, tenor, and asset/liability risk measurements. Considering the current funding landscape, let’s make a few quick observations that will help serve as the basis for our debate.
The short end of the current funding curve, the various Fed programs to address liquidity issues, and the current Fed
funds target rate suggest it may be some time before short-term money market rates rise. Further, current Fed funds probabilities are showing a Federal Reserve that will remain on hold for nearly all of 2009. This will, of course, be to subject to future economic forecasts for unemployment (currently about 8.00%+), inflation as measured by CPI (currently about -.5%) and real GDP (currently about -1.50%). Depending on one’s monetary policy belief, the empirical evidence is heavily skewed toward a zero interest rate policy (“ZIRP”). Employing the Taylor Rule,1 which provides a formula for appropriate short-term rates, based on expected and actual ouput and inflation, one could argue that the real Fed funds rate should be negative or at least zero for quite some time. Thus, the Fed has initiated many other liquidity programs to foster the flow of funds in distressed asset classes and unsecured funding markets—TAF, TALF, PDCF, TCLF, ABCP MMMF, CPFF to name a few!
But I digress…
With all of this evidence suggesting a protracted period of low short-term funding rates, why term out? Well, one may term out to manage to a portfolio mandate and take advantage of opportunistic intermediate- and long-term funding levels. In the case of the Knockout Putable, one can term out to book longer-dated funding well below current bullet advance rates, while assuming an acceptable amount of option risk. That’s a strategy that may cater to all stakeholders, but let’s run the numbers to confirm.
As many members know, the Seattle Bank offers “short-option” structures like the Knockout 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.
A putable advance offers lower all-in advance rates relative to no-option bullets, as
the borrower “sells” an interest-rate option and receives payment in the form of a lower advance rate. 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. 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.
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 | 2.85% |
As shown in Figure 4, knockouts currently offer a significant rate benefit relative to alternative funding structures: their indicative rates are 13 basis points cheaper per annum compared to four-year bullets and 44 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 five-year, non-knockout one-year structure is 128 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 1 year (Bermudan) w/ 6.00% strike rate | 2.85% |
| 5-year, non-put 1 year (Bermudan) | 1.57% |
| 4-year bullet | 2.98% |
| 5-year bullet | 3.29% |
*Indications as of January 28, 2009*
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
Take advantage of low short-term rates.
- Four-year swap rates are expected to reach approximately 2.40% in one year, suggesting that the straight five-year, non-put one year (Bermudan) at 1.57% is approximately 83 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.
Term out to mitigate refunding risk.
- Fixed-rate four-year and five-year swap levels, one year from now, are expected to be approximately 35 basis points higher, suggesting higher refunding risk one year from now.
Figure 5: Forward Rate Expectations
In this example with the Knockout Putable Advance, you are taking some liability sensitivity off the table, while prudently exercising the value of low shorter-term rates via the LIBOR strike rate of 6.00%. Ask yourself:
- “Will three-month LIBOR reach 6.00%?”
- “Can I live with 2.85% for five years?”
Evidence supporting the use of Knockout Putable Advance:
- Today, five-year funding costs 3.29% and five-year swap rates one year forward are +35 basis points to current levels. If you need up to five-year funding at 2.85%—44 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 1.70%. 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.
Our current Knockout Putable Advances suggest that taking advantage of low short-term rates and mitigating tenor risk via term extension do not have to be mutually exclusive. One can derive benefit from each trade, and do so within the construct of one structure. Knockout Putables allow members to take advantage of both ends of the maturity spectrum, while taking on an acceptable level of risk, with margin enhancing results. Now, that’s a trade that caters to all stakeholders!
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 Taylor Rule Equation: r= p +.5y + .5(p - 2) + 2, where r is Fed Funds, p is inflation over the last-year, y is percentage that GDP deviated from the Fed’s target.
2 Long option refers to the purchased cap, as the buyer is long the cap position because they have purchased it.
3 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.
4 Disclaimer: Forward rates are not accurate predictors of future spot rates.
Brett L.A. Manning, CFA, is a financial strategist at the Federal Home Loan Bank of Seattle.