Weighing Interest-Rate & Liquidity Risks

Longer-term funding rates have experienced a similar effect as short-term rates. As Treasury yields have declined, so have advance rates, and the spread between the two has tightened as well. The chart below shows the year-over-year path of the spread between two-year Classic Advance rates and two-year Treasury yields. Spreads on longer-term tenors are now back to normal historical levels — well below the height of the volatility earlier in the year.

So how can a member access long-term liquidity with exposure to short-term interest rates? Floating-rate advances may be the answer.

Floating-rate advances allow members to separate interest-rate exposure and liquidity protection benefits to meet their needs. The Discount Note Auction (DNA)-Floater Advance and the SOFR-Indexed Advance offer members different ways to keep the duration of liabilities short while extending their average life to protect against future volatility. 

In the case of the SOFR-Indexed Advance, the reference index is at the shortest point (overnight) on the yield curve. As the chart below shows, SOFR has shown an extremely strong relationship with the Effective Federal Funds Rate, which the Fed has communicated that they do not expect to raise until at least 2023.

Let’s look at an example of how using these floating-rate advances can provide short-term interest-rate exposure with some extra liquidity protection and save some interest expense as well. Here is a summary of a funding strategy that incorporates three different components:

1. 50% allocation to the six-month maturity SOFR-Indexed Advance: 

The advance rate resets daily at the current SOFR Index plus the spread of 25 bps, which is determined at initiation and is fixed for the life of the advance.

2. 25% allocation to the DNA-Floater Advance with a one-year maturity that resets monthly:

This advance reprices every month at a spread on top of the Office of Finance four-week discount note auction. Additionally, members can prepay the advance with no fee at every monthly reset, offering useful flexibility to pay down the advance if needed.

3. 25% allocation to the 12-month Classic Advance:

This offers some relative value as the fixed-rate advance curve is inverted out to one year.

As shown below, the result is that the combined funding reprices every 3.27 months but has a final maturity that is longer than that at nine months. Additionally, because of the flexibility afforded by the DNA-Floater Advance to prepay, the average life can be shorter than the maturity when it’s beneficial to the member to utilize that option. The blended cost for this combination is 0.35%, which is below that of the Classic Advance curve inside of nine months. Using the various advance solutions available when market conditions present opportunities can allow for members to tailor the interest-rate and liquidity risk that fits their balance sheet and reduces interest costs as well.

Our Financial Strategies group can work with you to identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644, 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.