How It Works: Discount Note Auction-Floater Advance

How It Works - Discount Note Auction-Floater Advance 

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Thank you for joining us today. My name is Andrew Paolillo.
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And today, we'll be taking a deeper dive into how one of our advance products works, specifically, the Discount Note Auction-Floater Advance, also known as the DNA Floater.
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PAUSE TO READ THE DISCLAIMER
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So we'll start things off by asking a simple question and saying, what is the Discount Note Auction-Floater Advance?
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So in the table below, you can see some of the basic characteristics for the advance and all the components that go into it.
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But to summarize, it is a floating rate advance, which the text up at the top really highlights the three main features of this advance.
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So, first off, because of the longer final maturity, it affords you a long-term liquidity profile.
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And then the second feature is despite that long-term liquidity, via the maturity.
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The floating rate nature allows you to gain short-term interest rate exposure, which may align with your ALM preference. And the last key feature of the advance is that it affords you prepayment flexibility.
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So at every rate reset, whether that is four or 13 weeks, whichever variety that you choose, you have the ability to prepay the advance without a fee, and we'll get into some of those details in a little bit.
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So we'll stick with the question format and ask, what are Discount Notes?
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So, if you're unfamiliar with that terminology, essentially, what it boils down to, they are simply short-term debt instruments that are issued by the FHL Bank system in order to fund our balance sheet to be able to provide advances to our members.
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So, every Tuesday and Thursday, the system offers an auction of Debt at maturities of four, eight, 13, and 26 weeks to dealers and to the investor community.
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And as of 12/31/22, it was a significant portion of the short-term interest rate markets such that there was 470 billion of Discount Notes outstanding.
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So when we think about the DNA-Floater Advance, the four- and 13-week maturities that are issued at auction every Tuesday and Thursday serve as the basis or the index for the floating rate event. So you can see in the table on the right-hand side.
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Recently, the four- and 13-week Discount Notes were issued at 438 and 463, respectively. And as we'll see in a little bit, that is that a very narrow spread to Treasury bills at matching maturities. So for more information about Discount Notes, the Office of Finance website can be found at www.fhlb-of.com.
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So how exactly does the advance work?
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So, you know, when we think about what goes into that all-in rate, there are two components.
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There is the index, which is going to reset and change as short-term interest rates change.
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But then there's the spread component, which is fixed and locked in for the duration of the advance.
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So you can see here in the visual, the first section outlines what happens to the index that changes over time. So whether you take the four-week variety or the 13-week one, you can see that every four weeks or every 13 weeks, that index or rate will be subject to change.
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In the second section, we can see that the spread is fixed all across.
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So whether rates go to 4%, 10%, or 0%, that spread component of the all-in rate is unchanged.
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And to re-iterate the prepayment flexibility, you can see at each one of those rate resets.
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Every time the index adjusts, you, the member, have the option to fully or partially prepay the advance without incurring a fee.
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So, looking at the table on the bottom, give some examples of recent pricing for the four-week variety of the DNA-Floater Advance with different maturities. So, you can see the one-year maturity advance priced at a spread of 25 basis points.
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And as you move further out the curve, as you might expect, for longer liquidity, that the spreads begin to widen 30 basis points at the two-year mark and 49 basis points at the five-year mark.
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And then, you can see the all-in rates for the initial rate along the right-hand side. And, again, that will be subject to change, and short-term interest rates change. But the spread component, the 25, 30, or 49, will remain unchanged as long as you had the advance outstanding.
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So now we'll ask the question, we know with Discount Notes are, and we know how they work in the context of the advance, but is there a strong correlation between other short-term rates?
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And the quick answer is yes.
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So what we're looking at here is comparing, since the beginning of 2022, the rates on four-week Discount Notes versus the comparable term of one-month Treasury Bills.
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 And we're also looking at the 3-month T-Bill versus the 13-week Discount Note.
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And as you can see, given how tightly clustered these ratings are, that as we began the rising rate portion of the interest rate cycle in mid-2022 and rose at a rather brisk pace, we can see that Discount Notes were very tightly correlated to where 1-month Treasury Bills and 3-month Treasury Bills were.
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And, in fact, if you squint a little bit, you can actually see some instances where Discount Notes were below the rate on the comparable term treasuries.
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Which is, you know, there's a lot of dynamics that go into play in the short-term interest rate markets.
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But as you as the markets grapple with things like T-Bill supply shortages and things of that nature, that oftentimes investors will flock to Discount Notes to capture yield.
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And members via advances are the beneficiaries of those low or negative spreads versus treasuries because it’s ultimately going to lower the funding cost that you will receive through advances.
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Now, let's go back in time a little bit to see how the DNA Floater and Discount Notes have performed historically in periods of extreme market volatility.
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So here what we're looking at is 2019 through 2021 but specifically highlighting the rather volatile period that we saw in March of 2020.
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So, while this is a little bit of apples to oranges because LIBOR is not in the equation as a tool like it was back then, the market has had a multi-year transition away from LIBOR to SOFR, and other short-term indices.
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And this is the point to drive home here is that it's always wise to have locked-in spreads ahead of periods of elevated volatility and stress that we never know when exactly that is going to rear its head.
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But looking at how LIBOR widened out when we did see that extreme volatility in March of 2020. And then, we see what the all-in costs for the DNA Floater was.
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And we saw how low Discount Notes were relative to LIBOR, and we can see that it benefited those members who had long-term liquidity but with floating rate exposure, heading into this period of falling rates. Yet widening spreads.
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So let's look at a couple of applications of how depository members can use the DNA Floater.
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So if we look at the table on the bottom, we can compare taking a one-year maturity four-week reset DNA Floater at a rate of 463 and compare that to the hypothetical example of bringing in retail CDs at 4% either with a one-year, excuse me, one-month majority or a 12-month maturity.
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​So for the CDs, it's pretty straightforward.
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When we think about the average life and the repricing frequency. It's essentially going to match the stated maturity for the CD, assuming that they're fixed-rate CDs.
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But with the DNA Floater, you have the benefit of separating out the interest rate component and the liquidity component.
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So you get the benefit of having a 12-month maturity.
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So if we were in a scenario where the fed pauses and pivots to rate cuts versus the hiking cycle that they've currently been on, then the DNA Floater would rapidly adjust downwards in terms of the rate.
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But you'd still have the benefit of the longer average life supporting your illiquidity metrics.
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So now, you may be asking, well, why would I borrow at 463 versus the hypothetical 4% on a CD?
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Now, just looking at those nominal numbers doesn't take into effect the marginal cost of funds.
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So, this is a dynamic that is at play for many members right now, where you may have a posted CD rate looking to grow or retain deposits.
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But some portion of that money going into that product may be coming from existing deposits already on the books at lower rates.
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In contrast to whatever portion is coming from new money outside of the institution.
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So when you look at how much that new money is actually costing, it goes, goes beyond just the posted rate.
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You have to take into effect the cannibalization from those existing depositors, moving from low-cost rates to these market rates, so let's look at an example here. 
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So, by looking at the cannibalization rate, so if we look to the right-hand side of the graphic and if we assume a 60% cannibalization rate now and we've heard anecdotally from members that they've seen programs where the cannibalization rates have even been much, much higher than that, but let's look at 60% because it's a good example.
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​That would mean that if you brought in $100 million in a CD special, that 40 million would be from new money outside of the institution. But 60% would be coming from existing depositors.
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So depending on where those existing depositors were previously paying, or excuse me, receiving, that would give you some insight into what the true cost was for that new money that you did bring it.
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So, here, we can see that if those existing deposits were coming from non-interest-bearing accounts.
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Then, the true cost of that money is astonishingly at 10%. So not that 4% positive rate, but actually, 10%.
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If they were coming from a 1% deposit rate, well, then that is north of 7%.
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And then, even if the existing deposits were already on the books, at 2%, maybe they were to a higher cost CD special or something in that regard.
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The true cost of that money is actually 5% higher than that 463 that you'd be paying on the DNA-Floater Advance.
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So understanding the cannibalization rate and the profile of your existing depositors.
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It's a key component to managing interest expense but also juggling interest-rate exposure, as well as liquidity risk.
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Now, shifting from depository members to insurance company members.
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The typical use cases for DNA-Floater Advance very slightly to be expected, given the different business models of insurance companies versus depositories.
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But the key application there are many insurance company members use the DNA Floater for is in spread lending programs where they will use the DNA Floater to fund purchases of floating rate assets.
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So here we're looking at an example where you would use the DNA Floater.
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And often, the members will use the 13-week variety because that aligns with a three-month index.
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Where it historically was a three-month LIBOR or as the market transitions to using a three-month SOFR, there's going to be a high correlation between the 13-week Discount Note and those three-month indices.
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So you'll see here in the graphic that the index component is going to be very close and matched and resetting on the same frequency.
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So as short-term rates move up and down, the coupon on the asset will move in lockstep with the index on the floating rate advance.
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But the spread component.
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In the asset-backed security world, typically, we'll see spreads in excess of 150 to 250 basis points, depending on the type of asset and where are you are in the stack.
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 Whereas the DNA-Floater Advance, as we've seen previously, much narrower spreads between 25 and 50 basis points typically.
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So when you net that out, you know, you're looking at typically 100 to 200 basis points of initial spread.
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And, again, you have the indices that are going to be aligned from an interest rate risk perspective, but the bit, the true benefit of the Floating-Rate Advance is that you have the longer average life.
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That gives you some spread stability.
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And, certainly, as you're, as you're considering pre-payable, asset-backed securities, where that average life may fluctuate.
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Having that prepayment flexibility to contract the amount of funding that you may need because the asset has paid down or prepaid gives an awful lot of flexibility and control in making sure that that spread program stays properly aligned.
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So that brings us to the end of our case study here. We thank you for your time. Hopefully, that was informative and instructive and gave you some background on this very popular and very useful advance as you think about your funding needs.
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So, as always, if you have any questions or if there's anything else that you may need from our end to help you go about your day-to-day, we're more than willing to help and do what we can. So, please feel free to contact me directly or your relationship manager, and we will do what we can to help you out.
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​Thank you very much and have a great day.