Case Study: Discount Note Auction-Floater Advance
Case Study: Discount Note Auction-Floater Advance
Hello, my name is Dan Redmond, and I'm the manager of the Member Funding Desk here at the Federal Home Loan Bank of Boston. Today, I'll be joined by Financial Strategist John Kornacki, and as part of our case study series will be discussing and advance product that we feel offers a tremendous amount of value to our members, especially in the current market. That product is the Discount Note Auction-Floater Advance.
Discount Note Auction-FloaterAdvance, or as we commonly called DNA Floater, is hardly a new advance product. It's actually seen a tremendous amount of activity over the years.
It debuted back in 2005 and since then, we've seen members originate north of 450 individual DNA Floaters. And we've seen $116 billion dispersed in that product.
So even though it's seen some decent volume over the years, sometimes it feels like the DNA Floater does not get the credit it’s due. It's an attractive and flexible funding option and I just think that members need to be a little bit more comfortable and familiar with how it works. So, that's the job today: to get you a little bit more comfortable with this product and this advance solution.
So, how does it work?
1:08 The DNA Floater is a fixed-term, adjustable-rate and nonamortizing advance. You actually have the ability to choose the adjustment periods on it. So, the DNA Floater either adjusts every four weeks or 13 weeks, and it's adjusting based on the result of the prior day's discount note auction. I'll get into the specifics of what discount notes are exactly on the next slide. So more to come there.
The rate is quoted as a spread to DNs or discount notes.
And that spread is determined on the trade date. It typically correlates to the advance’s final maturity so, basically, the longer the term, typically, the wider the spread.
That spread is fixed for the term of the advance, and it does not change.
I mentioned we would get more into the index. This part of the adjustment which are discount notes, or DNs, which they are more commonly known.
DNs are the short-term debt issued by the Federal Home Loan Bank system.
They're available daily via the window program or each Tuesday and Thursday through an auction.
And it's those auctions that are the basis for the DNA Floater. That's when those advances are committed and when they price.
The Federal Home Loan Bank system is highly sought after and a well-regarded issuer and that helps keep demand for the system debt strong and really that that helps drive pricing.
So basically through these DNs and with the DNA Floater, you're locking in an adjustable-rate advance that prices directly to the Bank's cost of funds plus a spread.
As far as the specifics associated with the product, the DNA Floater can run terms out to 20 years.
It's a simple interest calculation for this product based on an actual 360-day basis. Interest is paid at adjustment, so if you pick the four-week or the 13-week adjustment period, you'd be paying interest either monthly or quarterly.
And all principal is paid at maturity.
The DNA Floater is pre-payable and this is one of the great features of the product.
I think this highlights the value that it offers in the flexibility associated with the DNA Floaters that these products can be prepaid, at adjustment in any adjustment date without fee. So regardless of the interest-rate environment that we're in, you can either prepay this advance
every four weeks if you have a four-week adjust, every 13 weeks if you have a 13-week adjust, without cost at par. So you can prepare the advance at any time if it's outside of one of those adjustment dates, then you are subject to a fee,
but you do go into this product knowing that you have the flexibility to walk away from the product without cost either every four weeks or 13 weeks depending on your choice at inception.3:47 So nice feature there.
As far as minimum size, we do show a minimum size of $2 million on the DNA Floater, but
don't ever let that be a roadblock to you.
If you're looking for a smaller amount than that, we've had some great success over the years pairing members up to get to an aggregated $2 million for this product and other products.
So maybe it's a matter of showing on a broad-based offering for the DNA Floater to generate additional interest or more likely if you have interest in a specific term or a specific product, other members do as well and what we'll do is we'll hit the phone lines and try to generate additional activity there to get over that that $2 million hump. So, keep that in mind
please going forward. With this product and any product, if you see a minimum and you have interest, definitely give us a call, and we're happy to work with you.
I had mentioned before about the DN auctions on Tuesdays and Thursdays. So we take orders for DNA Floaters, any interest that would be submitted to us on Tuesdays and/or Thursdays, we have a strict deadline -- all orders have to be in by 10:45.
4:54 So if you let us know by 10:45 how much and for what tenor, we will provide you with the spread and then we'll get the results for that auction to get final pricing on that first leg.
The settlement for these advances is next business day so T plus one and that would settle into your IDEAL account.
So before I turn this over to John, I just want to quickly cover some of the benefits associated with the DNA Floater.
It is another advance solution to help you meet your liquidity needs.
Really, given its structure and its flexibility, I feel like it's a very attractive alternative to either short-term or long-term advances, or other wholesale funding sources that you may be utilizing or looking to.
The product allows you the ability to match fund adjustable-rate assets.
I definitely don't want to take anything away from what John's going to talk about in his portion of the presentation, but I do know is going to cover the strong historical correlation between DNs and other short-term indices.
So this product allows you the ability to address the interest-rate risk component of these transactions. Address dependency ratio -- you may need to show a long-term funding commitment on your balance sheet and with DNA Floater, you can do that while still taking advantage of short-term rates and that kind of is a good segue into the next bullet point, which is participate in a declining rate environment.
The Fed has been very upfront about their plans to keep short-term rates anchored. So, pricing at the front end of the curve looks pretty attractive at the moment and may be worth taking a look at.
And, again, the additional benefit associated with this product is the ability to prepay the advance without penalty at adjustment.
If you need to actively manage your cash flows, or you see faster than anticipated paydowns on the asset side, or if you want to refinance the advance to extend the term or tweak the amount, remember, you have the flexibility to do so at each adjustment date so that really is a huge plus associated with this product.
So with that, I'm going to wrap up my portion of the presentation, and hand this over to John.
6:58 Thanks, Dan.
6:59 Now that you understand, you know, what the Discount Note Auction-Floater is, and, you know, the benefits of using it,
I'm going to expand on a few of these ideas and talk about some more specific examples.
So as Dan mentioned, the DNA Floater Advance is a great product
to fund adjustable-rate assets and that's both LIBOR-based assets as well as
SOFR- based assets. For many folks listening, right now, you probably don't have many SOFR assets on your books, if any, at all.
But, as LIBOR goes away and SOFR assets become more prevalent,
you can see how this product tracks SOFR.
And the chart here, what we're looking at is the four-week discount note auction compared to an adjusted 30-day SOFR.
As you can see, the relationship is very strong with these two rates.
Even with the market uncertainty during March and April, you can see that the high-quality debt from the FHLBank didn't have any missteps and moved in line with SOFR.
So from a funding standpoint, you know, if you're looking to match fund and not take any interest-rate risk, funding a LIBOR or SOFR asset with the DNA Floater makes a lot of sense and provides a lot of flexibility as Dan pointed out and I'm going to talk about more in a minute as well.
I want to dig into interest-rate exposure and liquidity management as it relates to the DNA Floater.
The diagram here is showing how often the rate resets, how long you can get term funding,
and then the ability to collapse the funding if you choose to with no prepayment penalty.
If you think about your balance sheet, exposure to the front-end of the yield curve may be beneficial either from an ALM standpoint or a tactical position but that may present issues from a liquidity standpoint.
I don't have to remind anyone here who's listening how much of a hot topic liquidity is in the regulatory world. But this is one area where the DNA Floater adds a lot of value.
When you look at many of your liquidity ratios the focus is on, you know, terms inside of one year. Because liabilities inside of one year can potentially be volatile and reflect negatively on your liquidity profile, … you may want to or need to extend liabilities past one year.
The DNA Floater solves this potential volatility.
You can take out a two-year DNA Floater with a four-week or a 13-week adjustment, which gives you the liquidity protection against volatility but provides you short-term interest rates.
In a time where the Fed has been very clear on where, you know, they see short-term rates, you can position yourself in a way that minimizes costs while managing volatility.
And as we've already talked about, you have the ability to prepay with no fee at the reset dates.
So if you're managing your liquidity profile, for example, as the term gets inside of one year, you can collapse the funding and take out a new longer-term DNA Floater.
In addition to the example like that, you also have times where you no longer need funding due to deposit inflows, asset prepays or changes to your balance sheet.
We're now going to look at how the DNA Floater has performed in volatile conditions.
You know, there's really no better example than the extreme volatility we saw last spring in March and April of 2020.
And, as a proxy for volatility, this chart that we're looking at here, is showing the spread between three-month LIBOR and the three-month Classic Advance, as shown by the green line.
And also, I'm showing the 13-week discount note auction rate during the same time period.
As market volatility picked up and hit its peak at the end of March, you see the FHLB system saw very minimal impact. You see rates started to come down in February and then when volatility spiked, rates continued to come down.
So, even as, you know, markets experienced turmoil, you could have locked in a one-year funding at a spread of 25 basis points or all in at 35 basis points
when you account for … the spread that FHLBank Boston used.1
And even in highly volatile and uncertain markets, this product allowed you to manage risk at relatively cheap funding.
So, this is something to keep in mind as you manage your balance sheet through uncertain times.
The last topic I want to touch on here is how you can take advantage of pricing opportunities that, you know, makes sense both economically but also from a strategy standpoint.
This table is looking at pricing when I put this slide together, as well as looking at historical spread changes.
As you can see, and looking at current pricing, the one-year, one-month DNA is at about 37 basis points, which is one basis point cheaper than the one-month Classic
and about even with a three-month Classic.
If you combined some of the things we talked about earlier to your balance sheet needs, this is how we determine the best fit for your institution.
So, as an example, let's say you are currently rolling one-month Classic Advances to fill a funding gap.
You don't know how long you will need to roll
which is why you're staying short. If we look at this table, I pulled data back to 2017 and ran a scenario where I took out these various advances and rolled them to a 12-month horizon.
As you can see, regardless of which product you're looking at, you have risk in rolling the advance.
For this one-month Classic example, the spread actually widened 44% of the time with a median spread change of 3.5 basis points.
That means that at each one-month roll, there is a 44% chance the spread widened when you needed to roll the funding.
So when you look at this example and compare it to the DNA Floater, you know that the DNA Floater removes the spread risk as you can take out a term as long as you need.
And in this example, it's very clear which product would benefit you
and that's the DNA Floater.
You save one basis point in cost, remove spread risk, afford yourself the ability to collapse funding at each one-month mark, and you manage liquidity risk.
This is just one example
but, as I said, you look at this from the perspective of where the pricing is and what your needs are.
If the DNA is more expensive than the comparative Classic Advance that you're looking at, then you have to decide what's the value of having the DNA and is it worth it?
You know, do you need the ability to prepay?
Do you need longer-term liquidity? Or do you need to manage stable spreads? These are all things to consider when you look at this product.
We covered a lot here, but … we wanted to make sure if you're unfamiliar with this product, you'll walk away understanding how it works, what the benefits are, and how it can help you meet your funding goals.
With long-term liquidity management, you can take this product out to 20 years or whatever you need, and this helps you manage your regulatory and balance sheet goals.
Short-term price exposure allows you to fund short-term on the short-end of the curve to manage costs and interest-rate exposure.
Spread management as we talked about allows you to manage unexpected market turmoil through longer-term funding.
No … prepayment fee allows you to collapse the funding at the rate reset date to help you manage deposits inflows, asset prepays, and changes to your balance sheet.15:44 Strong correlation to … floating-rate asset indices, such as LIBOR and SOFR, allow you to match fund loans and investments, where you can decrease interest-rate risk exposure on your balance sheet.
And stable funding you know when market spreads widen and uncertainty is elevated, FHLB debt has performed well and allows our members to manage their balance sheet in these conditions.
And then the last thing I will say on this slide is, you know, as the yield curve has steepened in recent weeks and there's the potential for more steepening,
this is a product to keep your eye on as the curves steepens.
When you think about this product and the fact that it's an adjustable-rate product, as the curves steepens, adjustable rates become cheaper.
So if you want short-term rate exposure due to the Fed guidance or needs in your balance sheet, you may see even more pricing benefits with this product compared to our Classic Advances. So keep this on your radar as we move forward and in this environment.
That's all for our presentation today. Hopefully, you found some value in walking through the case study with Dan and myself and took away something of value to talk with your team.
The recording and PDF version of the slides are available on our website, along with other case studies, webinars, and articles we've written.
If you have any questions, feel free to reach out to Dan, your relationship manager, or myself, and we'd be happy to help out.
Thanks again for listening in today and have a great rest of your day.