Investment Leverage Opportunities

The fourth quarter of 2021 saw a sea change in the timeline for, and magnitude of, expected hikes in the Fed Funds range. In a matter of just a few months, market expectations went from forecasting one to two hikes in 2022, to potentially three or four. The Fed has initiated the tapering of their Treasury and mortgage-backed securities buying program, and after a short period of operating smoothly, they further accelerated the tapering pace. Inflation readings continue to run high, with much debate over whether it’s a short-term effect of current supply chain and labor disruptions, or a more permanent fundamental shift.

While being an armchair economist is a favorite pastime for many, more practically from our members’ perspectives, ultimately what matters is the available rates on targeted assets and liabilities. In that vein, yields on a popular asset class for depositories, mortgage-backed securities (MBS), have improved considerably of late. The rise in rates has come from both a lift in Treasury yields as well as a widening of spreads.

Spreads tightened over a multiyear period (albeit from a higher point than where they are at today) during the periods of tapering (light blue section of the line graph above) and reinvesting only (light green) and widened as the Fed shrank its balance sheet (dark blue). The period between when tapering ended and when tightening began was around three years, much longer than what is currently being hinted at. This accelerated timeline may be a key driver of why spreads are widening (and may widen further in the near term) ─ a welcome sight for balance sheet investors like banks and credit unions that have excess liquidity to deploy.

The current benefits of improved MBS yields come at a time when most depositories are grappling with margin compression. The past two years saw strong, and in many cases, record earnings from banks and credit unions, supported by income garnered from the Paycheck Protection Program (PPP), elevated gains on sale from the mortgage refinancing boom, and sharply reduced cost of funds. 

But looking toward 2022, balances of PPP gains are nearly exhausted, mortgage banking activity has slowed down (even before the recent rise in rates), and cost of funds has mostly bottomed out while loan yields and growth continue to be pressured. For many, leveraging strong capital levels, enhanced asset sensitivity, and excess liquidity can be a path to combat shrinking margin while still maintaining flexibility.

Below we will look at three different advance solutions that can be useful in instituting an investment leverage program. With yields on 15- and 30-year MBS near 1.75% and 2.50%, respectively, the opportunity exists to earn more than 100 basis points of net spread.

In Finding Relative Value in Floating-Rate Advances we discussed how it may seem counterintuitive to seek out floating-rate funding ahead of potential Fed hikes, but current narrow spreads on the SOFR-Indexed Advance create a margin of safety for the floater to outperform the fixed-rate alternative, even as short-term rates begin to rise. 

In the example below, a six-month SOFR-Indexed Advance priced at a spread of +20 is compared to using a six-month Classic Advance at 0.55%. Even if the Fed increased rates three times within that six-month timeframe (March, May and June), the total cost for the floating-rate SOFR-Indexed Advance would still be eight basis points less than the fixed-rate Classic Advance. If the pace of hikes moves slower, the outperformance will be even greater.

A common theme of late, from conversations with members, as well through call report analysis, is that many balance sheets are positioned as firmly asset sensitive. This may allow for the ability to naturally absorb the interest-rate mismatch of investing long and funding short. The SOFR-Indexed Advance allows for a cost-efficient alternative that may align with your balance sheet’s interest-rate risk management needs.

Another floating-rate alternative, the Discount Note Auction-Floater Advance, provides great flexibility in allowing for the member to prepay the advance at each reset interval (either one month or three months) for no fee. This advance allows for an efficient way to recalibrate funding needs if deposit growth or asset paydowns accelerate. 

Aside from the flexibility and control, the DNA-Floater presently offers some cost savings compared to the Classic Advance. Compare the one-month Classic Advance at 0.36% versus a DNA-Floater with a one-year maturity and a rate that resets every month, currently priced at a day one all-in rate of 0.29%. The DNA-Floater offers savings of seven basis points for the first month. At the one-month mark, the member has the option to revisit and reassess, which means they can hold it at the attractive spread, pay it down (if funding is no longer needed), or prepay and re-borrow in a new structure if desired (i.e. if a fixed-rate alternative offers better value).

Despite the recent run-up in intermediate rates, some members may feel their balance sheet positioning calls for mitigation of interest-rate risk, rather than funding at the front end as previously discussed. This may be applicable to institutions that have seen capital levels move lower due to extraordinary deposit growth and/or have already begun to add more long-term assets than is typical to deploy excess liquidity. The Member-Option Advance can be a useful way to extend, but like with the DNA-Floater, retain flexibility to call the funding when it’s in the member’s best interest. 

Consider an example where a member buys MBS yielding 2.25% and funds it with a two-year maturity, one-year lockout Member-Option Advance at 1.50%. The strategy would produce 75 basis points of spread for the first year, and the member can elect to prepay the advance after the lockout period. If rates go lower, there may be potential cost savings in re-borrowing (if needed) in a lower rate environment. If rates go higher, the member can elect to retain the advance.

Alternatively, it may be beneficial to call the funding even in an up-rate scenario. As noted in Revisiting the Last Fed Taper and Rate Hike Periods, deposit betas are likely to remain low for the first few rate hikes. Taking advantage of modest deposit betas might allow the member to replace the funding cheaper even as rates are rising. If four hikes occur, the member could potentially market a deposit special at 0.50%, a fraction of the 100-basis point hypothetical move in short-term rates. This would more than double the spread being earned on the transaction.

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.