Managing Cost of Funds with a Lower and Steeper Yield Curve

In the wake of the COVID-19 pandemic, financial markets experienced almost unprecedented levels of volatility during the month of March. Even as longer-term Treasury yields plummeted as investors focused on the return of principal (as opposed to return on principal), the Federal Funds rate dropping by 150 basis points led to a steepening of the yield curve.

The graph below shows the level of steepness between various tenors of the Treasury curve — three-month vs. one-year, one-year vs. three-year, and three-year vs. five-year. Since the beginning of 2019, all of those intervals have produced averages that are at negative levels, highlighting how the current curve steepness is a departure from the flat and/or inverted yield curve environment that has been prevalent for over a year.

The inverted yield curve that occurred during the third quarter of 2019 gave members the opportunity to reduce interest expense on existing borrowings where greater savings could have been achieved by extending liabilities further out the curve. In the current environment restructure opportunities still exist, but often the potential savings are maximized at shorter points on the curve as outlined below.

The chart above compares current and historical advance curves (when the curve was inverted on 9/3/19), as well as the new rates for restructuring an advance with an estimated 1% prepayment fee.

Due to the inverted curve last September, the rate that could be achieved by restructuring into a two-year advance was 37 basis points higher as compared to a five-year advance (2.42% vs. 2.05%). Because of the current positively sloped yield curve, the new rate at the two-year mark is six basis points below the rate at the five-year mark (1.36% vs. 1.42%).

Efficiently managing cost of funds is a key issue for all members. However, extending borrowings may not always necessarily align with the unique ALCO needs of the balance sheet. The current shape of the yield curve affords the opportunity to lower interest expense and keep liabilities shorter.

In periods of market stress, members turn to FHLBank Boston advances to strengthen on-balance sheet liquidity. During the volatility in March, many members utilized advances with maturities between three months and 12 months to guard against potential credit issues, cash flow disruptions, illiquidity in the bond markets, and uncertainty with deposit growth and retention.

Extending the maturity of fixed-rate funding may allow for greater peace of mind from a liquidity perspective, but with a positively sloped yield curve, the trade-off is a higher interest rate. For asset-sensitive institutions, the added liability duration may not be ideal from an interest-rate risk perspective.

One way to benefit from the liquidity benefits of long-term funding but maintain the pricing and duration of the short-end of the curve is with the Discount Note Auction-Floater (DNA Floater) Advance.

The chart below shows pricing on April 2, 2020 for Classic Advances from three to 12 months as well as a DNA Floater Advance with a 12-month maturity that resets quarterly. The steeper yield curve allows for favorable rates on the floating rate advance — four basis points below the comparable three-month Classic Advance.

With 23 basis points of steepness between three-month and 12-month rates, the DNA Floater Advance would allow a member to secure funding for one year and keep exposure and cost tied to the short-end of the curve.

When the yield curve is positively sloped, staggering maturities can create an all-in rate that is below that of a bullet advance with a matching average life.

For example, the chart below compares the historical rate on a 12-month Classic Advance and a 12-month average life ladder of advances (maturities at every three months, from six to 18 months).

In the first two months of 2020, selecting the bullet would have typically resulted in a lower rate — by as much as six basis points. However, since rates have fallen and the curve has steepened, the ladder has produced the lower rate, sometimes by up to nine basis points. At such low nominal rates, every basis point has that much more impact on overall funding costs — the recent cost differential from the ladder equate to savings of 5%-10%.

Recent market conditions have created many new challenges for FHLBank Boston members. Our Financial Strategies group can work with you to identify the funding solutions that best fit the unique needs of your institution’s balance sheet. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com or 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.