Hedging Against Higher for Longer with Flexibility

With the yield curve inverted at the start of 2024, market-implied expectations were for at least six to eight short-term rate cuts over the next 12 to 24 months. However, since the Fed began cutting rates in September 2024, intermediate rates have risen sharply, leading to a flatter yield curve, and accordingly, the prospects of further rate cuts have waned.

Since the start of the rate-hiking cycle in 2022, many depository institutions have experienced notable swings in their interest-rate risk profile. “We used to be asset sensitive, but now we are liability sensitive” has been a common refrain.

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While there are signs that margin pressure from low-yielding fixed-rate assets and rate-sensitive deposits is beginning to moderate, reigning in interest-rate risk exposures back to targeted levels remains a primary goal for many members.

As noted, low-yielding fixed-rate assets continue to pose challenges for members. The combination of yield, spread, duration and convexity are likely sub-optimal for many securities and loans added when rates were extremely low in 2020 and 2021. While the passage of time and some (fleeting) strength in intermediate rates has helped moderate unrealized losses, the market value of many of these assets remains well below their cost basis. As such, one strategy members have considered is selling these assets at a loss to recalibrate the balance sheet’s interest-rate risk while taking the hit to capital and current earnings to improve future earnings.

​Extending funding can have a similar impact on interest-rate risk measures as selling long-duration securities but with key differences related to the impact on capital and the income statement. Additionally, there can often be hesitation in using such strategies, given the concern of rates moving lower shortly after executing such a hedging tactic. With five-year rates 100 basis points higher since the fall and approaching multi-year highs, realizing the bond portfolio loss or locking in long funding can seem like the right strategy executed at the wrong time. Alternatively, as the last 2½ years have shown, not sufficiently hedging the risk of rates staying or going higher can also have adverse effects.

A strategy for members who would like to tamp down interest-rate risk exposure without taking a large one-time hit to capital and earnings is using the Member-Option Advance. As the name of the advance implies, the member can pay back the advance before maturity without incurring a prepayment fee. From a risk measurement standpoint, this allows the member to utilize the duration benefits of the advance’s final maturity but still retain the flexibility to return the advance earlier on the call date if it’s advantageous.

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Below are factors to consider when analyzing the Member-Option Advance, specifically, the 10-year maturity, one-year lockout, one-time call version of the advance. 

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Let’s consider an example where a member with $1 billion in total assets is considering a strategy of selling $50 million (or 5% of assets) par value of securities with a duration of five years, at a loss of $7.5 million (15%). The impact on regulatory capital ratios would be a reduction of ~0.75%, with a similar effect to the income statement. Assuming the proceeds stayed short in cash, the impact on the Net Economic Value, or NEV test for credit unions (for banks, the equivalent metric would be Economic Value of Equity, or EVE), would be a ~0.75% improvement post-300 basis point shock.

Another alternative would be to utilize the 10-year/1-year one-time call Member-Option Advance at a rate of 5.90%. At a duration of ~7.5 years, the advance contributes ~100 basis points of post-300 basis point shock value to the member, more than the impact of selling securities. The effect on near-term earnings is a reduction of only three to four basis points, the result of the interest expense on the advance and less income on cash or short-term investments. The magnitude of that pales compared to the ~0.75% hit from selling securities. 

Another benefit to hedging interest-rate risk in this fashion is that it does not give up the upside of potential price appreciation in the securities if interest rates fall. Let’s consider a scenario where interest rates declined by 100 basis points over the next year. Those long-duration securities would likely see significant improvements in market value. Since the member owns the option on the funding, there could be opportunities to reprice the funding lower, leading to margin expansion.
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When an interest-rate shock is applied to a balance sheet, longer liabilities offset some of the adverse movement in long-duration assets. The 10-year/1-year Member-Option Advance does just that, with a duration of over 7 ½ years. Assuming $10 million of the Member-Option Advance was used, to replicate that amount of duration benefit using Classic Advances, more borrowing would be needed to provide the balance sheet with the same level of interest-rate protection.

In addition to being more efficient by receiving interest-rate protection using only $10 million instead of $17 million to $77 million of borrowings, the strategy is also effective from the perspective of minimizing interest expense. As the chart below shows, the Member-Option Advance requires the least amount of borrowing and comes at a lower total cost to achieve the same amount of interest-rate protection. In addition to that, it also provides the most flexibility, given the ability to prepay the advance at the call date without being subject to a prepayment fee.

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com ​or reach out to your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.  The content of this article is provided free of charge and is intended for general informational purposes only. FHLBank Boston does not guarantee the accuracy of third-party information displayed in this article, the views expressed herein do not necessarily represent the view of FHLBank Boston or its management, and members should independently evaluate the suitability and risks of all advances. Forward-looking statements: This article uses forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is based on our expectations as of the date hereof. All statements, other than statements of historical fact, are "forward-looking statements," including any statements of the plans, strategies, and objectives for future operations; any statement of belief; and any statements of assumptions underlying any of the foregoing.. The words "expects", "may", “likely”, "could", "to be", "will," and similar statements and their negative forms may be used in this article to identify some, but not all, of such forward-looking statements. The Bank cautions that, by their nature, forward-looking statements involve risks and uncertainties, including, but not limited to, the uncertainty relating to the timing and extent of FOMC market actions and communications; economic conditions (including effects on, among other things, interest rates and yield curves); and changes in demand and pricing for advances or consolidated obligations of the Bank or the Federal Home Loan Bank system. The Bank reserves the right to change its plans for any programs for any reason, including but not limited to legislative or regulatorychanges, changes in membership, or changes at the discretion of the board of directors. Accordingly, the Bank cautions that actual results could differ materially from those expressed or implied in these forward-looking statements, and you are cautioned not to place undue reliance on such statements. The Bank does not undertake to update any forward-looking statement herein or that may be made from time to time on behalf of the Bank.