Case Study: Strategies to Deploy the SOFR Flipper Advance
Hi everyone. Thank you for joining us today for our latest case study, Strategies on Deploying the SOFR Flipper Advance.
My name is Andrew Paolillo, and I'm the director of Member Strategies and Solutions here at the Bank.
So, the plan for today is, we're going to look at three different funding strategies -- funding with rolling short-term advances, funding with a longer term fixed-rate borrowing, and utilizing the SOFR Flipper advance.
And we're going to run through a couple of different scenarios, depending on the amount of, and timing of, rate hikes that we may see over the next 12 months. And then we'll take it one step further in regards to the Flipper and see what happens after that initial lockout period, whether the advance is put back or if it flips to a fixed rate.
So, with the Fed having hiked rates in March and indicating that there's a number of hikes due to come on the horizon, that has injected a fair amount of volatility into the markets and the yield curve.
So, it makes the question of how and where do we fund our balance sheet that much more important, given all that is going on.
So, here to just set the baseline for the assumptions we're going to be using in the analysis today, we're going to look at a strategy of funding short with rolling short-term advances. In the assumption that cost will be SOFR plus 18 basis points. Now, that can be for a floating rate advance or a very short-term Classic Advance. As a proxy, the second approach will be to fund a little bit longer, with a fixed-rate Classic Advance. So, here, the assumption is a 12-month Classic at a rate of 182.
Then, the last example will show the SOFR Flipper Advance.
If you're not familiar with this advance, this is a floating- to fixed-rate product, where the member grants FHLBank Boston the option to put back the advance after designated lockout periods.
So, the example here assumes it to be a five-year maturity, a one-year lockout period, and during that lockout period, the rate that you will pay will be SOFR less 25 basis points.
And then if the advance is not put back at the end of that one-year lockout period, the advance would flip to a 2.28% fixed rate for the four-year remaining term.
So, let's look at the first scenario, which is that of an aggressive Fed hike cycle.
So, we're going to be assuming 250 basis points of rate hikes over the coming year with 50 basis point hikes in May and June and then at every Fed meeting thereafter 25 basis point hikes. So now this is an aggressive schedule, but it's also what the market is currently implying.
So, when we look at the chart on the right-hand side, we can see the rolling funding cost for the three different strategies.
Now, it makes sense that the dark gray bar, up top, the fixed-rate advance, the 12-month fixed =-rate advance, is a straight line going across.
You can see for the SOFR Flipper and the rolling short they are gradually rising over time as short-term interest rates rise. Now, the two things of note here.
As you can see, the strategy of rolling short, the light green bar, gets very close to the 12-month Classic rate once you get to the end of the horizon, relative to the very, very low level that it started out at. So, this makes sense because, you know, what we know about the yield curve is that it builds in future expectations. So, there's certainly no free lunch when you think about short-term advances being lower than long-term advances, that there is an expectation implied from the market about where short-term rates will be going.
The other thing to note here is that the SOFR Flipper Advance produces a cost about 45 basis points below that of the fixed-rate advance and the rolling short strategy.
And that is a function of the structure of the advance that allows the rate to be below SOFR.
So, if Scenario 1 wasn't an aggressive hike cycle, one that is currently being implied by the market, let's look at what happens
if we assume even more hikes, which would lead to rates rising
by more and faster than what the market is currently forecasting.
So, in this second scenario, we're going to look at a total of 350 basis points of rate hikes, with 50 basis point hikes coming over the next six meetings in 2022, and then only 25 basis points of hikes for the first two meetings in 2023.
And so, the shapes of the chart on the right look very similar to what we saw in the first scenario.
But, as you can see, now, the floating rate advances, the rolling short and the SOFR Flipper now get to and cross over the 12-month Classic.
So, now, this makes sense intuitively, if short-term rates rise faster than what the current market expectation is, then locking in a fixed rate ahead of that would be advantageous.
So, that's why you see the 1.82% for the 12-month Classic producing a lower interest cost.
Then, the rolling short strategy of 2.27%. However, because of the negative spread to SOFR6:18afforded by the SOFR Flipper Advance, the total interest cost across the 12-month horizon for the SOFR Flipper is within a few basis points of the 12-month Classic alternative.
So, our first two scenarios looked at what happens if the path of rates goes as expected,
and what happens if rates go up more than expected.
So now for the third scenario, let's look at what happens if rates go up by less than what is currently being forecast by the market.
So here, we'll look at just 100 basis points of hikes over the next year, including a 50-basis point hike in May, 25-basis point hikes in June and July.
But then the Fed hits the pause button.
And this is a discussion for another day, but given the inversion of the yield curve at longer tenors and many other factors occurring in the economy and the markets, you know, I think that this is a scenario that I wouldn't be too terribly surprised to see ultimately play out.
Now, what we look at in terms of the total funding cost here, because the amount of rate hikes is significantly less than what is implied today, we can see that funding at the short end of the curve, either rolling short or via the floating rate
structure of the SOFR Flipper that the total interest cost is significantly less in those two options versus extending out to the 12-month Classic Advance. So, you can see that the Flipper at a total cost of 83 basis points is almost 100 basis points less than the 12-month Classic Advance. And then, there's considerable savings in the rolling short strategy as well.
So, here's a summary of the total interest costs for the three different strategies under the three different scenarios. So, we can see, obviously, the 12-month Classic is going to produce a 1.82% interest cost in all different scenarios.
But the rolling short and the SOFR Flipper is going to vary depending on the path of rates.
If rates go up more than expected, then the cost on those two options are going to rise.
But if, like we saw in Scenario 3, the Fed underwhelmed with rate hikes, then the rate paid on the rolling short and the SOFR Flipper is going to be significantly less than the fixed-rate option.
So, when we have a 12-month Classic Advance, or we are rolling short-term advances, it's very simple.
When we get to the end of the 12-month horizon, we line up our maturities, and then, there's nothing left there. In terms of potentially having advances still on the books, the SOFR Flipper is a little bit different, because it has that five-year maturity. And that put option, where the advance either may go away, or it may stick around and flip to a fixed rate.
So, whether the advanced flips or not will depend on the level of rates and interest rate volatility at that time.
So, when we think about the different scenarios here, we know that the higher rates are, generally speaking
it's more likely that the advance will be put and not flip, as you can see in scenario one.10:08If we assume that, at that point, so for that 2.77%, then it's unlikely that the advance will flip, to that 2.28% fixed rate.
remember, that was where we had more rate hikes than what’s currently being forecast, that if SOFR at that point is at 3.77%, then the chances are very low that the Flipper will flip. And then in the last scenario where rate hikes are lower than expected, it is possible that the advance will flip to the 2.28% fixed rate.
So, and we're going to get into that in the next two slides about how you would then analyze the interest cost in that scenario.
So, let's take a deeper dive into one of the instances where there's the possibility that the advance may be put back to the member at the end of the lockout period.11:12So here we are going to look at scenario 1, which if you remember, was 250 basis points of hikes, which is currently the market's expectation.
And in this scenario, as we pointed out in the previous slide, that it would be unlikely that the advance would flip to the fixed rate of 2.28%.
Given SOFR at 2.77%, and the rest of the Treasury yield curve in the high twos or low three most likely.
So, in terms of the total rolling funding cost, we can see in the light blue that over the first year, you pay 137 for the Flipper Advance given the assumed path of interest rates.
Now, at that point, once the advance is put back, it may be time to dust off a strategy that has been on the shelf for most of 2020, 2021 and 2022 so far, in that taking advantage of the ability to raise deposits at below SOFR and below Treasury yield curve rates.
So, in this analysis here, we're assuming that once the advance gets put back, that you're able to replace that funding amount with deposits at a rate of 1%.12:39So, as you can see, the rolling funding cost starting at 137 at the end of the lockout period, gradually it goes down over the course of the next four years.
Getting close to that 1% level you can use any number or assumption you'd like in terms of the average cost on those deposits.
But even if you were to run this at 2% or 3%, the rate would still be significantly lower
than where term rates are here today in the beginning of 2022, and a big part of that is the … negative spread that is afforded from the structure of the SOFR Flipper.
So, that covers if the SOFR Flipper goes away, what happens if it flips and sticks around?
So here, we're going to look at scenario 3, which was where we assumed only a 100 basis points of hikes, which is well below, what is currently being implied in the market right now.
And in that instance, the probability of the advance flipping to the 2.28% fixed rate is higher than when we'd look at it in the previous two scenarios.
So, similar visual here to the previous slide where we can see the rolling funding cost for the SOFR Flipper in that first year.
And then once that 228 kicks in, we can see in that light green line, that gradually over time, that total funding cost continues to rise.
So, it goes from 83 basis points at the end of the lockout period and then moving closer to just under 2%.
At the end of the five-year horizon, now it's important to know, look at where five-year Classic rates are today at 291.
So even in this scenario, where the advance flips, the total cost over the 60 months pales in comparison to taking out the five-year advance today.
So, let's summarize some of the key points of consideration as we assess the funding options that are available to us and that may make sense in the current environment.
So, the first thing to point out is that, you know, what the Fed is talking about
the path of rates may be over the near term, has really led to some sharp changes in the shape and level of the yield curve, particularly on the front end.
So, from our members perspective, the cost to extend out a few months just to six months or 12 months comes at a considerably higher day one cost than funding at the very short end of the yield curve.
And some of that uncertainty in terms of the path of Fed rates, as well as the geopolitical happenings in Russia and Ukraine right now, have led to a sizable increase in interest-rate volatility.
And volatility can be interpreted in many different ways, but one of the ways to make volatility work for you is through structures like the SOFR Flipper Advance where you are granting the ability for the Federal Home Loan Bank of Boston to put back the advance. And by granting that option, you're able to realize a lower rate both on the front end and on the back end of the advance.
And, what's interesting about how the SOFR Flipper may have appeal in this particular environment is, as we saw in the scenario analysis, that it can have appeal depending on if rates move higher or if they stay lower than what is expected to be. So, it's by no means a directional bet.
So, if we think about what happens, and to summarize, if rates move higher, remember, that creates a greater likelihood of the advance being put back and not flipping to the fixed rate. And then, the task at hand for the member, is to replace the funding, which may or may not be needed given what could be happening on both sides of the balance sheet
at that point with either deposit growth or with paydowns on the asset side.
So, in that instance, you would have realized a lower cost of funding all along the way, and if you do need to replace it, it may be at advantageous levels as well.
And if rates move lower or stay relatively flat, the advance may convert from a floating to fixed rate, but, again, by capturing rates that were below SOFR for that first 12-month period,18:06not only have you banked those interest cost savings, but we can see that the all-in cost,
even if it does flip to the fixed rate that would be below that of Classic Advances that are available today.
So, there's opportunity to benefit depending on which way short-term rates may go in the future.
So that brings us to the end of the case study. Thank you very much for joining us, and I invite you to remember to check out our website, where there's a number of information about our various programs and products, and our strategies and insight section, where you'll see this case study
as well as other forms of content on product education and various strategies that may be of use to you.
So, thank you again for your time today.
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Thank you very much and have a great day.