Finding Relative Value in Floating-Rate Advances

Since mid-September, market expectations for the timing and magnitude of potential increases in the Fed Funds rate have changed considerably. The chart below shows the market implied rate for Fed Funds in December 2022. After exhibiting little volatility, and a very slight upward trend for most of 2021, conditions have changed, and pricing now reflects an outlook that short-term rates are likely to be rising in 2022.

The move has been so sharp that the odds of one hike happening (to a range of 25 to 50 basis points from the current 0 to 25 basis points) are up just slightly, while the odds of two (to the 50 to 75 basis point range) and even three (75 to 100 basis point range) hikes occurring have jumped considerably. Contributing to this change in expectations are an economy that continues to recover from the pandemic, signs of (potentially transitory) inflation in economic readings, and the Fed announcing plans to taper their Quantitative Easing program.

A by-product of the recent market movements has been that spreads on certain FHLBank Boston advances, such as the SOFR-Indexed Advance, have narrowed. At first pass, utilizing floating-rate funding ahead of expected rate increases may seem counterintuitive. However, as balance sheet managers know, the markets serve as a pricing mechanism of expected future states, and quite often in bouts of volatility like we are seeing right now, the pendulum can swing too far in one direction and create appealing opportunities on the other side.

After pricing in the 22 to 30 basis point range for months, recent spreads on the 12-month SOFR-Indexed Advance have moved lower ─ to between 14 and 18 basis points. With the SOFR index at 0.05%, an advance spread of +18 would produce a day one rate of just 0.23%. By comparison, 12-month Classic Advances were recently priced at a fixed rate of 0.45%. As shown in the chart below, for an advance with a 12-month maturity, this differential between the fixed rate and the initial floating rate is now much wider than it has been over the last year.

In past hiking cycles, the Fed ultimately raised rates slower and by less than what the yield curve originally implied. While it’s uncertain if that will be the case again, we can analyze what value may be captured by using the SOFR-Indexed Advance if the Fed did hike at a slower rate and by less than what the market is projecting.

The graph below shows a scenario analysis of taking out a one-year SOFR-Indexed Advance now and comparing the all-in cost versus a one-year Classic, assuming the Fed hikes rates in July 2022. Since SOFR and Fed Funds have historically had an extremely strong correlation, we assume in this analysis that SOFR adjusts upwards by 0.25%, when Fed Funds increase. The magnitude of the current spread (0.22%) between the floating rate (0.23%) and the fixed (0.45%) means that even if the last few months of the floating-rate advance are at a rate higher than the fixed-rate, the all-in cost across the entire 12 months still becomes the cheaper alternative ─ in this case by 15 basis points.

Even in a scenario with two hikes in June and September the all-in cost for the floating-rate advance would still be better than the fixed alternative by seven basis points. If you believe the Fed may move slower than the recently ratcheted-up market expectations, then there may be the opportunity to benefit from the narrow funding spread environment.

For members who use interest-rate swaps, the SOFR-Indexed Advance can be paired to create long-term fixed-rate funding. A popular strategy for some members is to utilize cash flow hedge swaps, where they pay fixed on an interest-rate swap of a longer maturity (such as three years) and roll short-term funding. This creates long-term interest-rate protection (but less liquidity protection), at attractive rates and spreads to comparable maturity Treasurys. Depending on the tenor, the member may be able to lock in funding costs just slightly above, or even below, that of the Treasury curve.

Aside from using the SOFR-Indexed Advance to gain long-term fixed-rate protection, another strategy would be to construct a shorter-term floating-to-fixed exposure. A member could take down the one-year SOFR-Indexed Advance and execute a forward-starting pay, fixed swap that begins after six months. This would convert the last six months of the 12-month floating-rate advance to a fixed-rate (at a level not much higher than the current six-month advance rate), leaving the first six months as floating. This would align with the view that the Fed may resist raising rates in the very near term (for example, until the currently outlined Taper schedule is finished), but the risk that hikes may accelerate in the middle of 2022 is one that may be prudent to hedge. The narrow spreads on the SOFR-Indexed Advance afford the ability to mitigate funding costs, no matter your rate outlook or balance sheet positioning.

Another factor to consider is that the activity stock dividend members receive when they take down an advance lowers the all-in cost of borrowing. Using the higher SOFR +200 dividend rate announced on October 22, 2021,* the all-in rate on a one-year SOFR-Indexed Advance at 0.23% would improve by approximately eight basis points, down to 0.15%. This matches the 0.15% depository members currently receive for reserve balances held at the Fed. The lack of negative carry may afford members the ability to be nimble in taking advantage of improved funding spreads and to be patient as opportunities to deploy into loans and/or investments materialize.

* Dividend rates are not guaranteed and subject to change. 

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com, or your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.