Taking Advantage of Market Volatility

Andrew Paolillo Icon
Andrew  Paolillo
March 16, 2021

As short rates have moved lower and longer rates have risen, interest-rate volatility has increased. These market movements have created improved opportunities to enhance earnings and manage liquidity.

Yield Curve Steepening

The shape of the yield curve has steepened dramatically in the beginning of 2021. This steepening has been driven by both a drop in short-term interest rates and a significant rise in long-term rates. Impacting the level of rates on the front end has been expectations of a decreased supply of Treasury bills. According to projections from the U.S. Treasury, the Treasury General Account is expected to shrink by more than $750 billion by March 31, 2021 and by over $1 trillion by June 30, 2021.

“A steeper yield curve and increased volatility create opportunities on both the asset and liability side to strengthen the balance sheet.”

A decreased supply of safe, short-term assets, coupled with consistently high demand, has led to downward pressure on rates for Treasury bills, repurchase agreements (SOFR), and even two-year Treasury notes. The chart below shows that since the beginning of the year, bill rates and SOFR have drifted towards 0%, and despite the long-end steepening, two-year Treasury yields have remained relatively constant.

Turning to the long end of the yield curve, we see a completely different story. While intermediate and long rates were rising since the middle of 2020, the movement in February saw an acceleration of that trend. Before February 2021, four out of the previous six months had seen a month-over-month increase in 10-year Treasury yields of at least nine basis points, with the other two months just slightly negative. During the month of February, rates rose by 31 basis points as compared to the end of January. If not for a sharp rally on the last day of the month, the differential would have been over 40 basis points.

Opportunistic Balance Sheet Management


A steeper yield curve and increased volatility create opportunities on both the asset and liability side to strengthen the balance sheet. As noted in Expanding Net Interest Margin and Using Advances for Just-in-Time Liquidity, excess liquidity has posed challenges for our depository members.


The recent movement in markets has improved spreads and yields on investment securities, enabling financial institutions that have been holding higher levels of cash to deploy that excess liquidity at more favorable levels.


On the funding side, increased volatility presents relative value in the HLB-Option Advance. Let’s look at some examples of how the recent activity has created opportunities for members.


Both mortgage-backed securities (MBS) and the HLB-Option Advance involve selling optionality. The MBS investor grants to the underlying mortgage holders the right to prepay at any time. With the HLB-Option Advance, the member gives the right to FHLBank Boston to put back the advance at specified dates. In both cases, this improves the rate to the member relative to a bullet instrument (an increased yield for the asset - MBS), and a decreased rate for the liability (advance). When volatility goes up, like it has recently, that option value increases, further enhancing the increase (decrease) in the yield on a new MBS (HLB-Option Advance). Both mortgage-backed securities (MBS) and the HLB-Option Advance involve selling optionality. The MBS investor grants to the underlying mortgage holders the right to prepay at any time. With the HLB-Option Advance, the member gives the right to FHLBank Boston to put back the advance at specified dates. In both cases, this improves the rate to the member relative to a bullet instrument (an increased yield for the asset - MBS), and a decreased rate for the liability (advance). When volatility goes up, like it has recently, that option value increases, further enhancing the increase (decrease) in the yield on a new MBS (HLB-Option Advance).


Consider the example below, which shows the change over a two-week span for the five-year Treasury yield, MBS spreads, and the HLB-Option Advance.


Treasury yields shot higher by 0.16%, and that volatility pushed MBS spreads wider by 0.18%. It also reduced the rate on a HLB-Option Advance (five year maturity/three month lockout with quarterly put) by 0.10%. Not only did the asset yield improve by 0.34%, which is appealing for those holding excess cash, but the potential funding cost declined.


A member whose balance sheet positioning would allow for accepting the interest-rate and liquidity risk profile of buying the MBS and funding it with the HLB-Option Advance would produce a spread of 132 basis points.

Date5-year Treasury YieldMBS Spreads5-year/3-month HLB-Option Advance Rate
2/10/210.46 %0.67 %0.25 %
2/24/210.62%0.85 %0.15 %
Change0.16 %0.18 %-0.10 %


Aside from strategies paired with asset purchases, the HLB-Option Advance can have value independently as a part of an overall funding mix — especially in the current low-rate environment. Historically, the primary risk of a putable advance was rates declining and having the advance extend towards its maturity date. However, given the current proximity to zero, conditions are different. Consider the five-year/three-month structure at 0.15% mentioned previously. In a hypothetical scenario where the advance remained outstanding for the full five years, the member would only cumulatively pay 0.75%. 


If we were to further stress test the example and assumed that the proceeds were not deployed into loans or investments but rather Interest on Excess Reserves (IOER) at the current 0.10%, the negative carry would be just five basis points per year. 


If IOER were to decline to 0%, the negative carry would be 0.15%. Given the absolute level of rates, rather than extension risk, the greater risk now may be that the advance gets put back and the low rates would have to be replaced with new funding.


The HLB-Option Advance structure affords great flexibility, because the maturity, lockout period, and put frequency can all be tailored to meet a member’s preference. 


As an example, let’s refer to the table below. A recent five-year/two-year offering with a one-time only put was priced at 0.35%. Similar to the five-year/three-month quarterly structure, it offered a discount vs. the comparable Classic Advance, to both the first put date as well as to maturity. But with the longer lockout period and one-time only put, the cash flow profile in different rate scenarios is more defined. This may be particularly valuable to banks and credit unions right now as they grapple with the stickiness of the record surge in non-maturity deposits over the past year.

HLB-Option StructureRateSpread vs Classic at First PutSpread vs Classic to Maturity
5yr/3mo Quarterly0.17%-0.17%-0.94%
5yr/2yr One-Time0.35%-0.14%-0.76%


Flexible Funding

Recent market conditions have created many new challenges 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 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. 

Andrew Paolillo Icon
​Andrew Paolillo
As vice president, director of member strategies and solutions at FHLBank Boston, Andrew leads the Strategy and Member Funding Desk teams in creating customized funding strategies for members.
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