By David Birkins

The Federal Home Loan Bank of Boston's Symmetrical Prepayment advance (SPA) offers members a significant advantage over its Classic advance. A member who prepays an SPA when rates are higher than the advance rate may be able to realize a gain on the prepayment.

This differs significantly from the Bank's Classic advance, which is normally subject to a prepayment fee equal to the present value of the Bank's lost cash flow. If a Classic advance is prepaid in a rising rate environment, the member can't register a gain because the Bank does not pass on the benefit.

Members prepaying an SPA in the same up-interest-rate environment would do so at "market value" * (less than par), allowing them to realize a gain. The option to prepay an advance at market value is what makes the SPA unique and potentially useful to members. The symmetrical structure makes it possible for the Bank to pass on to members any gain on the advance* less the present value of two basis points per year for the remaining term of the advance. This feature makes the advance similar to a repurchase agreement — without the associated headaches of dealing with "the street."

The SPA also offers advantages if interest rates fall. Under this scenario, the prepayment fee for an SPA is typically less than the fee for Classic advances with similar terms. The bottom line is that the SPA has a better prepayment profile whether rates rise or fall.

The Details
Unlike the Bank's Classic advance, the SPA allows members to prepay an advance at an amount that approximates market value. Without this feature, the SPA is substantially identical to our Classic advance. The SPA is a fixed-rate, fixed-term advance with monthly interest payments and a bullet payment of principal at maturity. Members pay no premium for the SPA. Pricing indications have been flat to the comparable Classic advance. The minimum size for an SPA is $10 million — a number based on the Bank's need to get effective execution of the underlying swap used in funding the product. The Bank periodically runs specials that enable members to participate with a minimum advance size of $1 million. The minimum prepayment amount is $1 million.

The Business Rationale
In the recent past we have seen increases in the Federal funds rate and similar, although not equal, increases in longer-term rates, resulting in a flattening of the yield curve. Given the uncertainty of the direction of interest rates, members are looking for cost-effective ways to manage both balance-sheet risk and margin compression.

The SPA effectively addresses both of these objectives. A longer-term SPA can be an excellent hedge against mortgage-related assets while at the same time allowing members to take a gain to reposition the balance sheet. In its simplest form, the SPA offers members an additional level of flexibility. Many members see fundamental value in keeping a portion of their funding liabilities flexible for repositioning — just as they would with their investment portfolio.

In a recent special, the Bank offered a five-year SPA priced two basis points below the five-year Classic advance. The table below shows estimated gains in rising-rate scenarios on several prepayment dates. If the advance were prepaid after one year (with a remaining term of four years) and interest rates had risen (100 basis points), members would realize a gain of $33,500 for every $1 million of advances prepaid. Members are still subject to prepayment fees if the advance is prepaid in a lower-rate environment (indicated by the negative numbers in the table).

The SPA offers many advantages over our Classic advance. With no price premium, the SPA has a better prepayment profile and offers members the ability to reposition funding liabilities to meet specific objectives. While the rationales for repositioning are manifold (interest-rate risk, earnings and capital management), the bottom line is that the SPA offers members a greater degree of flexibility than our Classic advance.

*The Bank passes through any gain (or loss) it realizes on the unwind of the swap used to fund the advance, as well as an administrative fee equal to the present value of two basis points per year for the remaining term of the advance. The amount of any gain passed through to the member is capped at 10 percent of the principal of the advance.

Please contact the Money Desk at 1-800-357-3452 or moneydesk@fhlbboston.com for more information.

David Birkins is vice president /relationship manager for Connecticut, Rhode Island, and western Massachusetts at the Federal Home Loan Bank of Boston.