Printable Version

April 21 , 2008

For members seeking to address balance-sheet sensitivity to increasing short-term rates, the Federal Home Loan Bank of Boston offers a new advance product: the HLB-Option Plus Cap advance, an HLB-Option advance with an embedded cap feature.

Like the standalone HLB-Option advance, HLB-Option Plus Cap advance is a fixed-rate, non-amortizing advance with an embedded LIBOR-indexed interest-rate cap feature effective for the lockout period. If LIBOR exceeds a predetermined strike rate during the lockout period, the embedded cap feature has the effect of reducing the advance rate below the initial rate. The notional amount of the embedded cap feature must be at least equal to the amount of the advance and no greater than three times the amount of the advance.

If the advance is not cancelled by FHLB Boston at the end of the lockout period, the advance remains outstanding at the initial advance rate for the remaining term or until the advance is cancelled. This advance is offered in Bermudan structures, cancelable on a quarterly basis after the lockout period, and European structures, which are cancelable on a one-time basis after the lockout period.  

Depending on the strike rate for the embedded cap feature, the advance may provide accelerated relief from sharp increases in short-term interest rates and may help members address balance sheet interest-rate sensitivity to increasing short-term rates during the lockout period.

At each rate-adjustment date, the effect of the cap feature is determined by comparing the current level of the index rate with the cap feature strike rate. If the index rate is above the strike rate, the effect of the cap feature is the difference between the two rates, which is applied as a reduction to the interest rate of the advance. If rates continue to rise, the advance rate will continue to decrease, but will not go below zero percent. Whenever the index rate is below the strike rate, the cap feature will have no impact on the advance rate. 

Generally, this advance would be most attractive to liability sensitive members but could also benefit asset sensitive members. By embedding a cap in this structure, liability sensitive members can realize greater interest-rate protection than their funding needs alone justify. Members that want to maximize their borrowing capacity can also obtain more interest-rate risk protection through the use of the HLB-Option Plus Cap advance.

Asset sensitive members can also use this product as part of a leverage strategy. If a member were holding long assets, it would be possible to fund them with equal amounts of short-term advances and an HLB-Option Plus Cap advance. If rates decline, the rate on the short-term funding would similarly decline. If the assets prepay in a falling rate environment, the amount of short-term funding could be reduced. If rates increase, the rate of the advance with the embedded cap feature could actually decline during the lockout period.

As an example, a member wants to extend its funding at below-Classic advance rates and is looking for additional rate relief on the advance should rates increase. The member chooses to take down $10 million of a five-year/three-year double notional cap advance with a strike rate of current three-month LIBOR, or 3.15 percent. The initial rate on HLB-Option Plus Cap advance is 3.61 percent. This rate will decline if the index (three-month LIBOR) exceeds the strike rate on HLB-Option Plus (3.15 percent) on any rate-adjustment date. During the lockout period, the advance rate will be adjusted every three months. Assume three-month LIBOR is 4.15 percent at the first rate-adjustment date. The advance rate would decline to 1.61 percent for the next three months, computed as follows: 

Initial advance rate = 3.61%

Effect of the cap feature (if LIBOR is above 3.15%) =

($ amount cap / $ amount advance) * (LIBOR – strike rate) = ($20M / $10M) * (4.15% - 3.15%) = 2.00%

Net adjusted advance rate = initial advance rate – effect of the cap feature = 3.61% - 2.00% = 1.61%

Standalone caps are usually quoted with an up-front premium. For this product, the cost of the cap feature to the member is included in the advance rate. In the event the advance is prepaid by the member, the member may be obligated to pay termination costs to render FHLB Boston indifferent to the member’s decision to prepay. If the proceeds from the termination of the cap feature exceed the amount the member owes FHLB Boston, no payment will be made to the member.

This advance may be attractive to members who are concerned with the management of interest margin compression that results from an increase in short-term interest rates. Liability sensitive members can use this product to extend their wholesale funding at rates below like-maturity bullet funding while providing additional margin relief in the form of a lower advance rate if LIBOR rises above the strike rate of the embedded interest-rate cap feature.

Before using the HLB-Option Plus Cap advance, members should carefully evaluate the unique features of the advance and how these characteristics will impact their balance sheet and income projections. We also encourage members to consult with their financial advisors and accountants to determine if an advance with an embedded cap feature is an appropriate strategy for them.