How It Works: HLB-Option Advance

How It Works: HLB-Option Advance Transcript

0:00 
Hi, everyone. Thank you for joining us today.
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 My name is Andrew Paolillo, and today's case study is the latest in our How It Works series, where we take a deeper dive and answer some questions about different types of Advance products. Today, we're going to be talking about the HLB-Option Advance.
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PAUSE FOR THE DISCLAIMER
​0:37 
So as we've done in past instances, we'll start out with a very simple term sheet, as you see on the screen here, that has the basic details of the Advance. And then, we'll also zero in on some of the key features. So the HLB-Option Advance is a fixed rate, like many of our Advances, such as the Classic Advance, that many are familiar with. But there's one key differentiating feature. 
0:47 
And that is that embedded into the Advance is the member selling the option to FHLBank Boston to be able to cancel or put the Advance prior to the final maturity, but only at pre-determined intervals. 
1:00 
In the next few slides, we'll get into what exactly that means for how the Advance is priced, as well as the A alignment balance sheet considerations of using the Advance.
1:12 
Now, we noted how the member sells the option to FHL Bank Boston for the right to put back the Advance at some point in the future. But as many of you know from other parts of the balance sheet, when you sell options, that improves the rate on the product that you're dealing with, with the tradeoff of having less control or certainty over the future principal cashflows. So, for example, many are familiar with how on mortgage loans or mortgage-backed securities, the asset owner is able to earn more spread by taking the prepayment risk when you give to the borrower the option to refinance. We have a similar idea on non-maturity deposits, right? 
1:32 
So being able to move your money around at any time has significant value to a depositor that, in theory, should mean that they're willing to accept lower rates in order to get that level of flexibility. So, when we look at the pricing on HLB-Option Advances versus option-free Classic Advances, which is what this chart is showing here, we see that HLB Options are priced below Classic Advances, in some cases, by a lot. 
2:15 
So, now, one of the dynamics here at play is the inverted yield curve, where long-term rates are below that of short-term rates. It is really what's driving this pricing differential. So, let's look at two examples that we have highlighted here in dark green. 
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We have the curve for two-year final maturity, HLB-Option Advances, and noted on the left is the two-year maturity with a three-month lockout period priced at 427. 
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Now if you're unfamiliar with what the term lockout period means, that just means that the timeframe at the after initiation of the Advance, where the Advance cannot be put back. So at a 427 rate, that is 130 basis points below, where three-month Classic Advances are currently at 560, so a pretty significant spread there. 
3:11 
Another example, moving down the page, is in dark blue, where it's the curve for five-year maturity, HLB Options. And in this case, it has a longer lockout of 12 months. This one being priced at 359. And when we compare that to where the 12-month Classic so comparing the Classic with the same term as the lockout period of the HLB Option, the savings for that initial lockout period are well over 170 basis points.
3:42 
So we saw on the previous slide and graph how there are a lot of different potential HLB-Option structures that have different pricing. We saw the range go from high two percents to the mid fours. So now, what factors in combination of factors determine how we get to the particular price on a specific Advance? There are four key components for us to be aware of here, and we'll go through them one by one. And essentially, what it boils down to is that all else equal, the more puts, the more optionality is being sold, and that leads to more improvement in rate. 
4:17
So the first factor that we'll talk about is the frequency of the puts. So for this example, let's compare, you know, what we have in the dark blue here. And that is a seven-year maturity, six-month lockout structure that has quarterly puts. And we'll compare that versus the light green example where we have the same maturity and lockouts seven-year, six-month but just a one-time put at the six-month mark. Now, because we have a greater frequency of puts in the blue example, the quarterly version it's priced about 25 basis points lower than the one-time structure. 
4:59
The second factor to consider is the length of the lockout period. Shorter lockout periods tend to be priced lower than longer lockout periods. Here we compare the dark blue versus the light blue, where we have a seven-year, six-month lockout, and we compare that versus a seven-year, two-year structure. And again, the six-month is going to be priced at a lower rate. The third factor for us to consider is the state of maturity. 
5:17
So again, we take our dark blue, seven-year, six-month structure. And we compare that to a two-year, six-month structure, where we have the same lockout period again. But a shorter final maturity, and we see the seven-year structure is priced significantly lower than the two year. And the last factor for us to be aware of on pricing for HLB options is how interest rate volatility is being priced and perceived in the market. 
5:52
So when we're in periods like the beginning part of 2023, when volatility and uncertainty on the path of rates is high. We have the scenario where sellers of options receive more premium or more rate reduction because we're talking about a liability here. There's more premium captured versus times when the market is expecting future interest rate movements to be much more benign versus this extremely volatile period that we're in right now.
6:26 
Now, we've talked a little bit about structures. We've talked a little bit about pricing. What about the cash flow profile of the HLB-Option Advance? So we've mentioned how when you sell optionality, the rate improvement that you are able to capture involves trading off the control and the certainty of the future cash flows of the principal. 
6:46
So, here we have a visual that shows how the average life or the timing of the return of that principle may fluctuate. And there are two key factors that make an HLB Option, either extend or contract. And that would be when rates are rising, that makes the Advance contract, and when rates fall. That may make the Advance extend. 
7:05
Interest rate volatility also plays a role. With all else equal, volatility decreasing leads to a higher likelihood of the put being exercised. Or said another way, the average life contracting, and increasing volatility leads to extension of the Advance or a lower likelihood of the put being exercised. So we can see in the graph here is that on the extremes, the potential average life is bound on the high side by the final maturity and on the low side by the lockout date. The average life initiation, or in the base case, is going to be somewhere in between the final maturity and the lockout date.  
7:46 
Again, there should be some similarity and familiarity given how mortgages work, but as we're talking about a liability, not an asset, like a mortgage. The results are flipped around in a mirror such that when we have lower rates, where that leads to a contraction of the average life in the mortgage, that leads to an extension in the average life of the Advance. And the opposite is true in rising rates scenarios.
8:16
 So, he will established that there are some potential for interest expense relief when using the HLB Option, as well as the potential variability in the timing in the return of the principal.
8:26 
So, it should be clear that utilizing the HLB option and then seeing rates remain either flat or go higher can be a favorable scenario due to the fact that you're, you're capturing cost savings versus other fixed-rate alternatives.
8:43 
What about when rates go down, and the advanced possibly extends?
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Well, we can do some analysis to that end to see exactly how far rates would have to go down for using the HLB Option to be a sub-optimal decision.
8:57 
On the left-hand side, what we're doing is some scenario analysis, and we're going to compare two different strategies.
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So we're taking a five-year one-year HLB Option priced at 359, and we're going to assume that it fully extends out to the five-year maturity.
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And we're going to compare that strategy with taking a one-year Classic Advance today at 536. And we chose that term because it matches the lockout period of the HLB Option that we're using here.
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And then, we're going to solve for that breakeven rate that, after we were faced that Classic Advance, what would the rate have to be on the funding for the last four years for the total cost to be equivalent to that fully extended HLB Option?
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So, what we see is that after paying the one-year Classic at 536 for years 2 through 5, that breakeven rate would have to be 315 to get us at the end of five years to be exactly 359, which is the rate on that HLB Option. So, that 315 rate is more than 200 basis points below where short-term rates currently are.
10:13 
So, you know, the structure and the price savings provide us a nice amount of cushion for rates to move lower and still maintain the total cost savings.
10:24 
Now, you know, we're assuming a pretty rigorous, stressed us here, that the Advance fully extends out to the five-year mark, but what if the drop in rates is more moderate, such that the Advance doesn't fully extend? And gets put to the 18-month, or 24-, or 36-month mark.
10:43 
And, on the right-hand side, that chart tests that sensitivity, and where we see that changing the horizon or shortening the horizon has a downward effect on the breakeven rate, which is a very favorable outcome for the member.
10:59 
So, if your outlook and, or balance sheet positioning is such that improving performance in some of those more modest downright scenarios.
11:09 
So, say maybe a -100 or -200, as opposed to the -300 or -400 scenarios, if that's something that you want to target, then this can be a pretty efficient way to accomplish that.
11:25 
As we showed, there are a lot of different structures that can be used, and this has been a very popular Advance for members in the current environment.
11:33 
What is interesting to me, at least, is that members are using a lot of different variations of the HLB-Option Advance in order to meet different types of goals.
11:43 
So we've seen a pretty balanced distribution of activity using different combinations of maturities and lockouts, whether it's liability-sensitive institutions who are extending the lockout period in order to tamp down interest rate risk.
12:00 
Or simply, members who have margins that are coming under pressure and they're looking the pull any lever they can to provide some cost of funds relief.
12:09 
So one approach that has been very popular of late, and as a function of the similar yet different dynamic that we're seeing in the yield curve today versus past instances where the HLB Option has come into play, is that there's a value in the shorter maturity structures.
12:27 
So, as we had mentioned a few slides back, the longer maturity structures tend to produce the greatest amount of cost savings.
12:35 
But because the rise in rates and the rise in volatility at the very front end of the curve has been so sharp over the last year, this has created the opportunity for cost savings on these shorter maturity structures. Where maybe historically, that hasn't been the case where the opportunity has really been in the longest final shortest lockout type structures much more narrower set.
12:59 
So here, what we're doing is showing a comparison of two different structures, a two-year, three-month, as well as a ten-year, three-month.
13:06 
And we're comparing what the spread versus the three-month Classic.
13:11 
And we're doing it as of December 2022, as well as today, in May of 2023.
13:18 
A​nd as you might expect, there's a greater discount on the Classic for the longer maturity structure, the ten-year, three-month.
13:27 
But if you remember, that creates a greater potential for extension risk if interest rates do fall.
13:35
 But note that the spread on the two-year, three-month structure, it was 77 basis points back in December.
13:41
Just continue to widen out 133 basis points here in May, and that creates the opportunity to get some not insignificant cost of funds relief, but also, at the same time, significantly limiting the tail or the extension risk you know, that is inherent to the Advance. So, you know, it's similar to how a seven-day Classic Advance and a 30-year Classic Advance may technically be the same Advance type.
14:11 
But practically speaking, we know that they contribute to totally different types of exposures if you were to compare them.
14:18 
So, in that same vein, take a look at some of the shorter maturity structures where the cost savings may be present with a much more defined downside risk profile than some of the longer-term structures.
14:34 
Well, that brings us to the end of this presentation. I appreciate you joining us.
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And as always, if there's anything that we can be of assistance, hopefully, you were able to add to gain some information and some knowledge out of this case study, please feel free to reach out to me or your relationship manager, or for any pricing or questions that you may have, and we'll be happy to do what we can in order to help you.
​15:01 Thank you very much and have a great rest of your day.