Case Study: Comparing Fixed and Floating Rate Advances

Case Study: Comparing Fixed and Floating Rate Advances
 
0:01 
Hi everyone. Thanks for joining us today. My name is John Kornacki. I'm a senior financial strategist here at the Federal Home Loan Bank of Boston. Today, we’re going to discuss comparing fixed- and floating-rate advances.
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We're going to start off here by going through the indices that our floating-rate products price off of. So, we have two here. The first one, the Secured Overnight Financing Rate, or SOFR, and the second one being Discount Notes.
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I assume most people are familiar with Secured Overnight Financing at this point, but just to go through it, you know, this has been endorsed by the Alternative Reference Rate Committee or ARRC as the preferred replacement for LIBOR.
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Over the last several years, as you know, we've been following in the news of LIBOR cessation,
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SOFR has been the choice there as a replacement and the Federal Home Loan Bank System has really been a leader in this transition over the last several years.
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SOFR is based off of transactions in the trillion-dollar repurchase, or Repo Market, and so that's a highly liquid market with significant transactions taking place every single day. And so, one of the issues with LIBOR was obviously that there wasn't a lot of volume. There wasn't a lot of pricing that took place.
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And so with SOFR, it's a robust market … that is transacting all day, every day.
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It's administered by the New York Fed and it reflects the cost of borrowing of overnight transactions that are collateralized by the US. Treasury securities.
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Then moving over to Discount Notes. Discount Notes are short-term debt issued by the Federal Home Loan Bank System. They're available daily via the window program or each Tuesday and Thursday through an auction.
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And those auctions are the basis for the DNA-Floater, and that's where advances are committed and when they are priced. Federal Home Loan Bank System is a highly sought after and well-regarded issuer.
2:17 
And that helps keep the, you know, keep the system debt strong, and really that helps drive pricing. These are our basically T bills, these are FHLB T bills, and so, very safe debt, and that allows us to offer highly competitive pricing out to our members. And so, we're going to discuss, you know what the actual Federal Home Loan Bank of Boston products look like, but this just gives you an idea of what the indices are and a little background on them.
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Now, we're going to talk about the floating-rate products that FHLBank Boston offers, 
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after the indices that we just discussed in the prior slide. So, the first product here is the SOFR-Indexed Advance. This is a floating-rate product with the floating-rate indices being the Secured Overnight Financing Rate.
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This advance is prepayable with a fee, and we offer it from one month out to 20 years.
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And so, when you take out the advance, it's based off of the Secured Overnight Financing Rate, plus a fixed spread. And that fixed spread is fixed for the life of the advance.
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And then the second product here is our Discount Note Auction-Floater Advance. We talked about what Discount Notes are.
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So, this is a floating-rate advance as well, with the floating-rate index resetting every four weeks or 13 weeks. And so, you have the option, when you take out the advance, whether you want the reset to occur every four weeks or 13 weeks.
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And the great benefit here is this advance is prepayable with no fee at each reset date.
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So, you can have it, if you chose a four-week reset every four weeks, you'd have the ability to prepay that advance without a fee. And again, we offer maturities from one month out to 20 years.
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Alright, let's talk about some pricing now.
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And so, what we're looking at is FHLBank Boston, advance rate pricing, as of January 24th. The green line represents our Classic Advances across the curve out to 12 months.
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And then the light blue Xs represent our day one, SOFR-Indexed Advance rates. So that's the SOFR Index plus a spread.
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And you can see the indices rates on the top left of this chart with SOFR at five basis points and the DNA index at three basis points. And so, you see that one-year/one-month DNA Floater Advance is priced at 28 basis points today.
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So, when you compare the one-month product to the one-month Classic, you see 10 basis point difference on day one with SOFR and nine basis points difference with the DNA Floater.
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And then you look out across the curve, 12 months. Spreads don't really widen under the SOFR product. And so, there's some significant difference in pricing from your Classic to floater.
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And obviously, you know, there's things to consider especially with a floating-rate advance that reprices daily and we're going to discuss that in the next several slides of how you can take advantage of that,
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especially as there's lots of discussion now with the Fed potentially raising rates several times in 2022.
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But even with that, there's opportunities to take advantage of a floating-rate product versus a fixed-rate product, when spreads are wide enough to take advantage of. So, we'll discuss in the next few slides.
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So, the way we're going to go through this presentation today, is we're going to look at a number of different scenarios, and we're going to take this, looking at whether you took out a fixed-rate Classic Advance versus the comparable SOFR-Indexed Advance.
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So, this first example here is we're looking at what if there's, you took out a three-month Classic Advance, or a three-month SOFR, and there's one rate hike of 25 basis points in March.
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So, you take out the advance on January 24th, there's a hike in March, and the advance then matures three months later. What's your cost savings there?
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And so, if we assume one rate hike here, you see that 46 basis points for a three-month Classic Advance.
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All in cost for the SOFR-Indexed Advance would be 36 basis points.6:58 So, 10 basis points of savings. So, depending on, you know, how you feel the Fed will will move over the next three months, will determine the savings that you may expect there.
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So, if you think the Fed is going to be more hawkish, those savings might be contracted compared to the 10 basis points. Or if you think they're going to be dovish and won't be able to raise rates or one hike is what you'd expect,
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you'd get some significant savings there. And so the ability to save when the spreads are wider for a floating-rate product versus a fixed-rate product, gives you more room. If the Fed does start to raise rates, you have the ability to still save below that of the fixed-rate comparable product.
7:54 
Alright, so now, we're going to look at another scenario here. This one is we're going to go out a little bit longer in term, and we're also going to get a little more hawkish with what the Fed does.
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So here we're looking at six months, and we're going to raise rates three times, 25 basis points each time.
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So, you can see that, you know, going out six months and raising 25 basis points each time, you still save with the SOFR-Indexed Advance.
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So, 63 basis points on the six-month Classic versus 60 basis points on the SOFR-Indexed Advance.
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So even raising 75 basis points on SOFR over the course of six months, you still get the savings. So we’re raising here in this scenario March, May and June.
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So if you think that, you know, the Fed is not able to raise in May and they have to push it back to June and then maybe July, the delay and hikes will also benefit you in getting greater savings versus the Classic Advance.
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Alright, so now, we're going to stress things a little bit.
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So, we're going nine-month Classic, so a much longer term, and we're going to say the Fed gets very hawkish. So there's pressure to raise rates and they raise faster than even the market anticipates right now. So, we're going to say five hikes.
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And so, you're going March, May, June, July, and September.
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And so, what happens when you raise five times over the course of the nine months.
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And you see that, you know, you would have saved more with the Classic Advance.
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However, it's a modest underperformance when looking at the SOFR-Indexed Advance. So it's 85 basis points versus 73. You may have thought when he took out the advance, the Fed wasn't going to be able to raise as quickly and they were going to be more dovish and, you know, maybe raise once or twice. And unfortunately, if you took out the floating-rate advance, they raised five times, but you don't lose out as much as you might think you would. Even with five hikes you are only underperforming 12 basis points.
10:21 
It's one of those scenarios where if the Fed goes slower than you anticipate, you went out a lot more than you lose if they go faster, and we're going to look at that on the next slide.10:34 Now we are going to look at and see how do you perform if the Fed is more dovish and they're not able to raise rates as fast as the market anticipates. So, we're looking at a 12-month SOFR- Indexed Advance versus 12-month Classic, so you have 81 basis points on the Classic.
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Now, we're saying that the Fed is not going to be able to hike as quickly.
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So, in this scenario we're saying that the Fed is going to hike 25 basis points in March and 25 basis points in July.
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And you see the results here, 22 basis points of savings there so you significantly outperform the comparable Classic when the Fed does not hike as quickly as anticipated.
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So, when you think about comparing the fixed versus the floating, as we discussed, when spreads are tighter on the floating-rate product and you're able to get, you know, more significant savings like now,
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when the floating-rate advancea versus the comparable fixed-rate, you know, it might seem counter-intuitive to take out a floating-rate advance, you know, when the Fed is expected to hike.
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However, depending on your conviction and how, you know, fast or slow, the Fed hikes will determine, you know, what the outcome here is and so in the last slide we talked about, you know, the Fed is going to hike quicker than expected and you were underperforming by 12 basis points.
12:06 
Here, they're hiking slower than anticipated, and you outperformed by 22 basis points. So, it's a little bit of an asymmetrical return, where in one scenario, you lose but lose out modestly and in the other scenario, you're much better off, and it's a much more significant difference.
12:28 
So, it's something to think about here as we're in a steeper yield curve, and even as the Fed is starting to talk about raising rates in the near term,
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there's opportunities here depending on, you know, how you're funding your balance sheet, what you're looking to do, the term that you're looking to go out to and comparing the fixed versus the floating-rate product and seeing the value in looking at the floaters right now.
13:03 
We're now going to switch gears here and look at our DNA-Floater Advance.
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If you've listened to some of our other content specifically talking about this product, you'll know that we've mentioned before that this is really an underutilized product, by our depository members.13:21 When you look at the chart below, you'll see why.
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There's significant opportunity here when you look at it in terms of pricing and the features of the product.13:32 And so, the green bar here shows our Classic Advance, so Classic Advances priced at 37 basis points. So let's take that three-basis point Discount Note index, as we discussed earlier, and say, calculate the implied spread that would get you to the 37 basis points.
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And that would be 34 basis points of implied spread above that of the Discount Note.
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Now, move over to the blue bar here over on the right here.
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This is a one-year/one-month Discount Note Auction-Floater.
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And so, you take that same three basis point index plus 25 basis points of the fixed spread that the DNA Floater is priced on today.
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That gets you to a 28 basis point all-in day one rate, and so that's a nine basis points savings from the one-month Classic to the one-year/one-month DNA.
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And, and as I mentioned earlier, this is repricing on a four-week or one-month reset.
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So, your rate is fixed for that one month, so you can either have a one-month Classic or you have a one-year/one-month DNA priced at nine basis points below,
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you still have the ability to prepay that advance without a fee every one month, and your spread is fixed out to one year. So, you're not taking any spread risk. If spreads blow out over the course of the next several months you don't have to worry about rolling that one-month Classic, and seeing what happens to the advance rate when spreads widen, because you fixed your spread for one year.
15:23 
So, as I have here on the top of the page, heads you win, tails, you flip again. So, you own the optionality, but you get paid with the lower rate.
15:34 
So, really, there's a lot of value here in looking at this, and, again, there's, when we're looking at, you know, a floating-rate versus a fixed-rate product, it's kind of counter-intuitive to think oh, a floating-rate product might be beneficial right now, especially as the Fed is going to be expected to raise rates in the coming months.
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However, depending on what you're trying to do with your balance sheet or how you're funding the floating-rate product, may be more beneficial than the fixed-rate product at this point.
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Thanks for tuning in today. As always, feel free to reach out directly to me or your relationship manager. Any of the scenarios that we talked about today, they can be customized.
16:20 
And we can kind of go through specific scenarios that, you know, may be of interest to you, and kind of playing around with, you know, what's the Fed going to do and how does this impact the rates on the floating-rate products. And specific terms that you may be interested in, as well. The terms are customizable to the needs of your balance sheet.
16:41 
So, we can price out specific terms that fit your needs. Happy to discuss this in more detail. Again, thanks for listening today, and have a great rest of your day.