Case Study: HLB-Option Advance
Case Study: HLB-Option Advance
Hi, everyone, my name is John Kornacki. I'm the Financial Strategist here at the Federal Home Loan Bank of Boston.
Thanks for joining us today for another edition of our case study series, this one titled HLB- Option Advance.
So just to start off here, I want to provide an overview of what the HLB-Option Advance is, how it works, and how it compares to our Classic Advance product.
So we start off on the left side here, this is a fixed-rate advance. Principal is due at maturity, or sooner if the option, if the advance is called, and we'll get into that in a minute. Putable-callable. So with the HLB-Option Advance,
you as the member, are selling the optionality to the Federal Home Loan Bank of Boston.
And, what that means is you're providing, you're giving the right to the Federal Home Loan Bank to collapse the funding prior to maturity date.
So, I like to frame this in a way that you can kind of compare it to your own retail customers.
So, if we take a retail CD, for example, and say it's a two-year CD priced at 50 basis points. How would you price that CD if … you allowed that member to collapse that CD after six months or a year with no penalty?
And the answer is, it would be somewhere cheaper than 50 basis points and the reason is … you don't know if it's a two-year CD anymore.
It could be a six-month CD, or it could be a one-year CD or somewhere in between, depending on the structure of that. And that's similar in the way that the HLB-Option Advance works ...
There is a final maturity, and then there's terms set where that advance can collapse prior to that date.
And so that brings us over to the right side of this chart.
And looking at … some of these features and … how these features go into whether there's a higher discount or lower discount, versus the Classic Advance.
So final maturity.
The longer the final maturity, the greater the discount typically versus the classic lockout periods.
So, [the] lockout period is that initial period where the advance cannot be called.
So if we take an example of a five-year/one-year HLB-Option Advance, that means the final maturity is five years, and the initial lockout period is one year so that advance will stay on the books for a minimum of one year.
That's how often the … advance can be called after that initial lockout period.
So, if we go back to the example I just mentioned, you have a five-year/one-year every six months.
It's a five-year final maturity/one-year initial lockout period, and the option to call the advance every six months until maturity day.
And so when you look at the components here and how they go into pricing, if you think about … what you're doing when you're selling optionality, that lockout period, if it's a shorter lockout period, more discount, you're gonna get a higher discount versus a Classic,
and the reason is you're selling that to the Federal Home Loan Bank. You're selling a shorter period where they can call it back and collapse the funding.
Same thing with the call frequency.
The more often the frequency, the greater the discount because that's more options for the Bank, to call the advance back.
Then with market volatility, the more market volatility there is, the greater discount versus a Classic Advance.
And we'll talk about … how this goes into pricing versus a Classic and … where you can take advantage of this on your balance sheets as well.
We're now going to take a look at some recent advance rates. So, we have the dark green line here represents our Classic Advances.
Then we priced out two separate HLB-Option Advance structures.
The first one is shown by the light blue line, is our five-year/three-month quarterly call. And then the darker blue line is the five-year/two-year one time called.
As we discussed in the last slide, we talked about the components that go into a larger discount versus our Classic rates. And, you know, to the components, driving a lot of that discount is the lockout period and the call frequency.
And so, when you look at the five-year/three-month quarterly call, you see each of the exercise dates as represented by the green axes.
So, with this particular advance structure, there is the option to call the advance after a lock-up period of three months, and then every quarter after that through five years.
And so when you think about the pricing on this one, there's a lot of optionality sold to the Federal Home Loan Bank of Boston, which is how you're able to get the cheapest rate here.
Now, with the five-year/two-year one-time call, there's a lockout period of two years.
And it's only one time that the Federal Home Loan Bank is able to call this particular advance.
And so that's priced at 35 basis points, which is 15 basis points cheaper than the Classic two-year.
5:39 This is just, I just wanted to show … some different structures here so you can get an idea of pricing and how the discount works,
but really what we're going to talk about in the next few slides is … how to use this to fund assets and understanding the risks that are involved,
and how to take advantage of those opportunities in the market right now using the HLB-Option Advance to fund your balance sheet.
So now we're taking a look at an example of how rates impact the average life of the HLB-Option advance.
And as we've touched on, … in selling the option to the Federal Home Loan Bank of Boston, there's the possibility that the advance is called away prior to maturity. And so, what we're looking at here is an example of what can happen to the average life as rates go up or down.
And so, as you can see as rates go down, the average life extends towards the maturity date.
And then as rates go up, the average life contracts towards the lockout period.
And so, you know, this is a simple representation but it's an important concept to understand,
especially when you think about how you want to fund the assets on your balance sheet, and how do you take advantage of the opportunities in the market right now, which we're going to touch on over the next several slides.
Now that we have an understanding of the product and how it works, we're going to shift our attention to focus on where we see value on balance sheets.
And, you know, first starting off by looking at some of the challenges that members continue to face, and that being continued margin pressure,
as well as lackluster loan growth, have really challenged members over the last year.
And so, when we look at those challenges, there's really, there's … two main opportunities to focus on where we can help mitigate some of that.
And the first thing, reducing deposit rates, and utilizing the HLB-Option Advance to replace run off.
Most of our members have done a great job in finding ways to reduce rates, but you know, the question we still have to ask ourselves,
is there more room? Have we looked at our entire stack of rates, including money market rates, for example?
And we're going to go into more detail on the next slide on this topic.
But first … the second opportunity is … funding investment growth. And many folks have been hesitant to extend investment duration, especially at … some of the uninspiring spreads that we've seen over the last several months.
But if we looked in more recent weeks, … there's been some really good opportunities to jump in with some … spread widening and steepening of the yield curve. So, we'll talk about some of those details as well and how the HLB-Option Advance can help facilitate that.
So, now we're going to kind of go into a little bit more detail on the opportunities that I just mentioned in the prior slide.
So, focused on the left side here, we'll start off with the first opportunity, and that's, you know, ratcheting down deposit rates and replacing any runoff with HLB-Option Advance.
As I mentioned, folks have done a great job … bringing down their CD rates and other term deposit rates as well as non-maturity deposit rates.
But one of the things to keep in mind here is … over the last year, we've seen significant surges in non-maturity deposits and … as we look at tepid loan growth and influx of cash, we have to continue to monitor these rates. And you know look to see … is there more room to lower?
So, the example I have here is someone pricing money market at 35 basis points.9:57 And so, if we cut that down to 15 basis points and monitor … what's the retention here?10:05 So anecdotally, what we've heard from a lot of members is that money is sticking around.10:11 It's not leaving, even when lowering rates significantly.
So, there's a possibility that you can go from 35 to 15 and not see any change, or even continue to see increase in deposits.
But, if that does start to run off a little bit, you have a relatively cheap funding source, and that's the HLB-Option Advance.
So, what we’re looking at here is a recent five-year/three-month advance at 17 basis points.
So, you are able to bring down your money market rate while having that backup if things were to run off more than expected, you can fill the gaps with the HLB-Option Advance.
Moving over to the right side here.
So, as I mentioned, there's some better entry points for investments than there have been over the last several months and … with loan growth not being there, you know, we have to find ways to put that cash to work, especially, … as deposits continue to surge.
So, what we're looking at here is investment yields.
As well as the HLB-Option pricing over the last month.
And so, we're looking at January 20th to February 24th and you can see that MBS yields have increased 36 basis points and in that time period, because of the volatility in the market, we've seen the HLB-Option Advance actually come down 14 basis points.
And so, when you look at that from a spread perspective, that's an increased spread of 50 basis points, and you don't see spread changes that significantly that often.
And so, this is something that we're going to talk about … what the tradeoff here is in a minute, because obviously, with this particular advance, there's the risk that it could be called away.
But if you can get a day one spread that's 50 basis points wider than previously, you're giving yourself some more room than you previously had.12:18 And we'll dig into that in one minute.
We're now going to take a look at how performance is impacted in different rate environments.
So, if we start on the left side here and looking at a rising-rate environment, obviously the biggest risk here is that the HLB-Option Advance is called away, and therefore, you have to replace the low-cost funding.
However, when we look at the advantages, and we see some of our members’ balance sheets, many perform better in a rising-rate environment.
So that disadvantage of funding having to be replaced can be offset by the benefit of loan and investment cash flows being replaced at higher yields.
And so, there's a lot of opportunity here in a rising-rate environment even if the funding has to be replaced.
Then in a falling-rate environment,
the advance potentially extends, and we look at the low-cost liability remaining as the biggest advantage here.
And the second being that we've maintained our deposit pricing discipline.
As we discussed in the last slide, we talked about money market pricing going from 35 basis to 15 basis points.
So, you're able to maintain that discipline, as well as maintain this low-cost funding source, which allows you to maintain wider spreads.
And the disadvantage here is, typically the biggest risk we see what this product is that [it] extends for longer than you'd like it to.
But right now, we're in a very low relative rate environment, so we go back to some of the pricing we saw earlier with the, say, for example, the five-year/three-month price is 17 basis points.
In a worst-case scenario, you can park your funds overnight at the Fed and earn a very low negative carry.
So if we look at this from a risk/reward standpoint, the risk is somewhat lower than the current rate environment, and when we compare the advantages and disadvantages, we see lower risk for the disadvantage then we have in prior rate environments.
All right, so we're going to finish off here with just a quick summary and bring everything together.
Hopefully, if this was your first time looking at the HLB-Option Advance this kind of gave you a primer of how it works and what to consider.
And then, if you're looking at this from an opportunity standpoint, hopefully, this kind of gave you some perspective on where you can take advantage of volatility, as well as some low relative funding costs.
And so, the takeaway here is revisit your funding. …where are your deposit rates?
Can you ratchet them lower and know that if there's runoff, … you have options to replace that runoff.
And then the other side of that is as we monitor the investment world with lackluster loan growth, there's potentially good entry points.
And if you can fund those in a way that makes sense with enhanced spreads, it can really help your balance sheets. So, taking all that into consideration and hopefully this … gave you some perspective on … what we're seeing for opportunities and how the HLB-Option Advance can be a great tool for this.
Thanks for listening in, as always. [I] truly appreciate the attendance and the feedback that we get from everyone.
If you have any questions, or just want to … discuss some more things, please reach out to myself or your RMs, and we're always happy to talk. So,
thanks again and have a great rest of your day.