​Case Study: Forward Starting Advance

Transcript

Case Study: Forward Starting Advance
0:00 
Hi everybody. Thanks for joining us today for another edition of our case study series, this one titled “Forward Starting Advance.”
0:11 
Before we start talking about FHLBank Boston’s Forward Starting Advance, I do want to talk a little bit about forward rates in general just to set a foundation if you're not familiar with what a forward rate is. 
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I
f we look at this top line here, you see a forward rate is an interest rate for a transaction that takes place at a later date. And so what does that mean?
0:32 
Everyone here is familiar with transacting in the spot market or are today's market, right. You price loans, you price deposits based on what's going on in the market today.
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There's also the need to price things for future transactions.
0:50 
And there's a number of different reasons why you would need to enter into a forward rate agreement, and we'll talk about those in a second here. But just so you know, forward rates are the market’s estimate of where rates are likely to be in the future.
1:05 
This particular example that I have here is looking at Treasury yields.
1:10 
And we don't have to look at Treasury yields, but it's, it's easy, everyone's familiar with treasury yields, so it makes sense. But just so you know, really any rate that has a yield curve has a forward market as well.
1:25
If we go back to this example here, I have Treasury yields going out to two years and that's shown by the green line.
1:32 
And then I have a one-year forward Treasury yields priced and that's the darker blue line. And these are going both out to two years.
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And the examples I have here are you have two options. Your investment horizon is two years for both of these options and your first option is to invest the money out to two years, so that'd be 14 basis points annually.
1:55 
The second option is to invest now at a one-year Treasury, and that's priced at five basis points.
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And then at the end of the first year, invest the proceeds into another one-year Treasury.
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Now, we don't know where rates are going to be in a year, so we have no idea what's going to happen after the first year.
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But the market does price in today what that rate will be one year from now.
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And if we look at the darker blue line here, we see, again, this is the one-year forward Treasury.
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S
o above the 12-month part of the curve, you see 23 basis points and that 23 basis points is the one-year Treasury yield one year from now.
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And if you were going to do option two, but you were going to protect interest-rate risk, you would invest five basis points for the first year. And today, … you would lock in your 23 basis points for after the first year.
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And that would make you indifferent to either option one or option two.
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And so forward rates are a way to hedge the interest-rate risk that you may have.
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And another example might be if you have cash flow coming off.
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Say you have some investments coming due in six months, and you know you're going to want to redeploy it.
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You're not sure about interest-rate risk and depending on the makeup of your balance sheet, you may want to hedge that risk.
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And so, you could enter into a forward rate agreement today to lock in future investment yields for when your current cash flow runs off.
3:32 
And so, these are just a couple of examples of the purpose of a forward rate.
3:37 
And we're going to kind of go into the math a little bit on the next slide.
3:43 
So, we're going to briefly just discuss the math behind forward rates here.
3:48 
If you remember, from the prior slide here, we had the example of two options, you go out to two years and invest at 14 basis points, or option two, invest one year, five basis points, and then another year after that And we didn't know where rates were going to be.
4:06 
And so, what you could do is you could invest to five basis points today and you could enter into a forward rate today as well.
4:14 
And we said that that forward rate would be priced at 23 basis points.
4:18 
And, you know, this is where we talk about, how do we get to … that 23 basis points?
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And remember, on the last slide, we said, … forward rates are the market's expectations of where rates will be in the future.
4:32 
And we're using the current spot yields to come up with the forward rates.
4:39 
And you can see and the formula here, we're looking at the two-year,
4:44 
and we're looking at the one-year, to determine what the price would be one year from now for a one-year maturity.
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And so that's based at 23 basis points. If you invested for one-year, five basis points and then next year at 23 basis points, that would make you indifferent to investing initially at two years for 14 basis points. And like I said that’s to make sure that there's no arbitrage opportunity where you can't take advantage of the market. And like I said, this is just an example.
5:15 
And this same concept goes across the entire curve of figuring out where forward rates will be and, and right here, we're only looking at a one-year forward.
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We could look at a three-month forward, we could look at a six-month forward, you know, out to all the way along the curve to figure out where the market is pricing for rates, and we can use that to hedge interest-rate risk on our own balance sheets.
5:41 
Alright now, we're moving into our Forward Starting Advance product.
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So just to give an overview here:
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What our product does is it allows you to lock in a rate today for future funding disbursement.
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The rates are priced off of today's forward rate market for future disbursement at any point out to two years.
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You could take out a one-year advance in six months from now, and why would you do that?
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And as we talked about before, one of the main reasons could be hedging interest-rate risk.
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And you can hedge rising rates that may happen over the next six months or over the next year or two to manage the risk on your balance sheet. So, if you’re liability sensitive, for example, you're more exposed to a rising rate environment.
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A forward advance allows you to manage that risk without needing the funding today.
6:45 
We can also look at it from the perspective of managing future loan growth.
6:49 
If you have a pipeline that you're putting on your balance sheet over the next six months, say, for example, you can lock in that funding cost today and not have to be exposed to fluctuations in interest rates over that six-month period.
7:05 
And so you can lock in that spread if you already know what your loan production is going to be.
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So common uses we've kind of touched on these already.
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But there's also the aspect of managing … anticipated deposit runoff.
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So if you're running analytics on your deposit growth and you're seeing that there's a risk that a portion of your deposits may run off due to competition or increase in spending, then you can manage that runoff and replace it with Forward Starting Advances. So if you know there's going to be a certain amount that's going to run off in the next year, you can set up a Forward Starting Advance to make sure that you lock in today's price and get disbursement from when you anticipate deposit runoff.
7:58 
Alright, just to kind of briefly go through some of the features that we have with this product.
8:03 
Same as other products here, we go out all the way to 20 years for this advance with the ability to delay funding up to two years.
8:12 
Y
ou could enter into a forward rate advance today, not get the funding for two years and then, take out a term out to 20 years beyond that.
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It's available in our Classic Advances, Amortizing Advances and Community Development Advances, as well, so it's not just the Classic Advance where you can use this feature.
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And then, also, just to point out here, it's continuously offered.
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Y
ou know, you might see it in some of our specials that come out, but you can always call the Member Funding Desk and be able to talk through an idea with them.
8:49 
So, we talked about some of the reasons why members might want to look at a
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Forward Starting Advance, and we have the protecting against rising rates. Are you liability sensitive and you want to protect against rising rates?
9:03 
We can look at different structures that might fit your balance sheet. Prepare for future loan growth.
9:09 
We talked about that as well.
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Do you have a pipeline that you're working on,
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and you want to lock in margins by entering into a Forward Starting Advance where you could lock in your rates today so that, you know, you're not susceptible to huge fluctuations in rates. And then, lastly, the deposit runoff that we talked about as well. So, we can talk about all these different, different options with you, and we can cater an advance specifically to what's going on in your balance sheet and what your needs are.
9:43 
I do want to point out some recent pricing. Just … if you haven't seen our forward rates compared to our Classic, this is just something I want to point out so you're aware of what's been going on in the market.
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So, this chart on the right here is showing a few different advance products. So we have the two-year Classic. As you can see, it's priced at 51 basis points.
10:05 
There's an 18-month advance with a six-month delay that's priced at 42 basis points.
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And then you have an 18-month Classic priced at 39 basis points. So, as you can see the forward starting has a nine-basis point discount to the 24-month Classic, and it has a three-basis points premium to the 18-month Classic. And so, you know, as we've already talked about throughout the previous slides, there's some opportunity there, depending on what your balance sheet is asking for, to take advantage of tight spreads and good pricing right now.
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And just another thing to point out, during that delay period, members do not have to purchase activity stock.
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Nor does the advance use up available collateral, so, keep that in mind
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if … you're worried about activity stock or collateral, neither is used during that delay period.
11:02 
So, I mentioned tight spreads in the last slide, and I want to put some numbers behind it, just so you can see what has happened over the last year.
11:11 
So, I have two examples here. Green Line is showing the two-year advance. First, the two-year Treasury.
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The blue line is showing the three-year advance first three-year Treasury. So, as you can see, both of these have tightened up. The two-year going from 43 to 35 basis points. The three-year going from 47 to 38 basis points.
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And so, what does this mean for the Forward Starting Advance?
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Well, it means that you can take advantage of these tight spreads with a Forward Starting Advance.
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If you priced out of Forward Starting Advance today, you're benefiting from today's tight spreads but you may not have to disburse that funding, you know, for six months, a year, or two years. And who knows where the market's going to go over that time period. So, you may not need the cash today, but you may need the cash in six months or a year from now, and you can take advantage of today's tight spreads and get beneficial pricing.
12:08 
We've already discussed all of these different strategies throughout the presentation today, but I do want to come back to them one more time and just run through them to make sure everybody understands, you know, how the Forward Starting Advance can help you manage your balance sheet.
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First topic here is managing interest-rate risk.
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As we discussed, liability sensitive members are more susceptible to rising rate environments. So, as rates rise deposit costs increase, margins are compressed. And so, the Forward Starting Advance can help you lock in rates today. If there is a rising rate environment, you've already locked in those rates.
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So, you may not need the cash today, as a lot of our members, are flush with cash.
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You can delay that funding six months or a year out to two, years for when you do need it, but manage that interest-rate risk effectively.
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The second one here is manage future liquidity needs.
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So, the three bullet points here are increased loan production expectations, plan for deposit runoff, or fund future investment purchases.
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We talked about the investment purchases earlier in the first slide, and it's really, you know you're going to invest that you have cash flow running off in, you know, six-months or a year.
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And you want to protect your balance sheet if rates fluctuate. The Forward Starting Advance can help you … lock in those rates for when you do need the funding. Plan for deposit runoff.
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There's a lot of deposits on balance sheets, and there's a lot of anticipation of, you know, will they run off? Will they not run off?
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And depending on the makeup of your membership and where the deposits came from, you know, you might be modeling out some runoff over the next year, two years.
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And you can lock in your rate, your funding rate, today and with the expectation of how you're modeling out deposit runoff and replace that runoff with today's rates.
14:07 
Then loan production. You can kind of manage those margins through the Forward Starting Advance as you increase your loan production over time.
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Then, the last section here is to replace future CD or advance maturities.
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So, if you have an advance, you know, say, coming due in six months, you know you're going to need to replace it.
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You're unsure or … your balance sheet is susceptible to a rising rate environment,
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you can lock in those rates today and have that and time it so that Forward Starting Advance starts once your current advance matures in the future and so that you're not exposed to any interest-rate risk in that gap.
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I hope the presentation today provides some value in learning more about our Forward Starting Advance product and gave you some ideas to manage your balance sheet and how our products can help you in some of those ways.
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We're always happy to help and continue the discussion offline, so please feel free to reach out to myself or your relationship manager, and we're always happy to discuss. Thanks for listening in today and have a great day.


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