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By John Baity

The Federal Home Loan Bank of Boston (the Bank) has introduced the Slider advance: a LIBOR floating-rate, fixed-term advance with a declining-rate participation. The Slider is a term advance that floats with LIBOR until LIBOR reaches a member-designated “strike” rate. At that point the advance rate takes on its “slider” characteristic: it declines at twice the pace of LIBOR, falling two basis points for every one basis-point decline in LIBOR. The advance suits members with an exposure to moderate-to-sharp declines in short-term interest rates.

With news of rising inflation and fears of further Fed tightening persisting, many members today may be focused more on rising rates than falling rates. But it may be wise to look in the other direction as well. After the Fed stops tightening, will your balance sheet be exposed to falling rates?  How much further can you lower core deposit rates that have not increased much during the recent 425 basis-point increase in the federal funds rate?  With the Slider advance, members now have the opportunity to manage this risk at an attractive cost. If your ALCO is discussing economical ways to reduce falling-rate risk should rates rise or remain flat, the Slider is an attractive instrument to consider.

Dynamics of the Slider Advance The Slider advance is a LIBOR advance with an accelerated rate drop when LIBOR reaches a member-designated strike rate. An interest-rate floor is a contract that pays the purchasing party a payment for the amount that rates fall below a certain “strike” level. This payment is in exchange for an upfront premium payment. Because the floor is embedded within the advance, the payment is in the form of an accelerated (two-for-one) rate reduction. Note that the rate on the advance can never fall below zero percent. This is what you would want if your balance sheet is exposed to falling rates.

Probably the easiest way to consider a Slider advance is to compare it to our pure LIBOR-indexed, floating-rate advance. We know that the rate on a pure LIBOR-indexed, floating-rate advance increases and decreases with changes in LIBOR, exhibiting a one-to-one relationship between the change in the advance rate and the change in the LIBOR index.

By comparison, when an interest-rate cap is embedded in a LIBOR floater (as it is in our Capped Floater advance), the relationship is a little different. When rates move above the strike rate for the Capped Floater advance, the repricing relationship is zero to one (plus the cap premium). But below the strike, it exhibits the same one-to-one as the pure floater. So its repricing character is described as nonsymmetrical about the strike rate.

The repricing for the Slider advance is also non-symmetrical about the strike rate. When rates rise above the strike, it behaves like the pure LIBOR floater, repricing one-for-one, albeit at a premium to reflect the cost of the embedded interest-rate floor contract. However, when rates fall below the strike - and this is the key concept - the advance rate falls at twice the amount of the decline in LIBOR. There is a double-bang-for-the-buck effect when rates fall.

After some initial rate decline below the strike, one can think of the Slider's benefit as absorbing the cost of its premium; beyond that point the benefits generated  incrementally offset the member’s falling-rate risk exposure from some other balance sheet dynamic.

Exhibits A and B present graphs that conceptually illustrate the repricing characteristics of the Slider advance relative to the LIBOR floating-rate advance, and the capped floater advance relative to the LIBOR floating-rate advance.

Financial Analysis: Modeling the Slider’s Impact on Net Interest Income Assessing whether the Slider works for a member’s balance sheet involves a straightforward exercise to model the financial effect on net interest income (NII). For each interest-rate-shock scenario, members will need to model two items and add them to their existing NII sensitivity projections:

• Incremental cost of the Slider over an alternative source of funds (call this “x”). This is the sum of: a) the premium in the advance rate for the floor protection provided by the Slider, plus b) the rate difference between the member’s alternate funding cost and the Slider’s LIBOR term funding. 

• Slider repricing benefit in dollars (call this “y”). This is the reduction in the advance rate owing to a decline in LIBOR below the pre-set strike level.

In terms of judging financial efficacy, the member’s objective, in the rates-falling-below-the-strike-rate scenario, is that the Slider repricing benefit, as measured by “y,” sufficiently offsets the incremental cost of the Slider, as measured by “x.”  In the rates-rising-above-the-strike scenarios, the objective is that the “x” is not deemed too costly.  A member who could use this type of advance has more exposure to falling than rising rates.

Below is an example illustrating how a member might model the Slider’s effect on NII. Assume the member is currently borrowing $10 million at a funding rate 25 basis points less than a Slider advance that has a 4.75 percent strike rate. For the sake of simplicity, assume only two rate-shock scenarios: LIBOR falls 200 basis points below the strike rate and rises 200 basis points above the strike rate. Current LIBOR is 5.25 percent. The rates are illustrative; actual rates depend on current market levels. The computation, following the above terminology, would be:

In the above example, the Slider was beneficial because it generated a fairly sizeable reduction in the member’s advance rate when rates fell, while only costing a minimal amount when they rose. The effect was offsetting to the member’s existing exposure to falling rates (that is, asset sensitivity). Specifically, the Slider helped to speed up the repricing of the liability side of the member’s balance sheet, consisting mainly of core deposits and term funding. When rates fell 200 basis points below the strike, the Slider rate repriced 175 percent of that decline. On the other hand, when rates rose, the Slider had a negligible effect, repricing only 17 percent faster than short-term borrowing rates.

It should be noted that several members are considering using a Slider in combination with term fixed-rate bullet advances. The rationale is that the Slider allows the fixed-rate funding to become floating in character when rates fall below the strike rate, while the fixed-rate funding anchors the rising-rate effect of the Slider. Members opting for this type of strategy are looking to reduce their rising-rate risk (that is, liability sensitivity) but do so in a way that preserves beneficial sensitivity to falling rates.  

We encourage you to discuss this new product with your financial advisor and our staff at the Bank, including your relationship manager, the Funding Desk staff, or Funding Strategies Department. 

For more information about Bank products and services, please contact Paul Peduto at 617-292-9762, or call John Baity at 617-292-9710, or Steve McHugh at 617-292-9616.

John Baity is vice president/relationship manager for northern New England at the Federal Home Loan Bank of Boston..