# Case Study: Match Funding with Flexibility

## Transcript

Case Study: Match Funding with Flexibility

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Hi everyone, and thank you for joining us for our on-demand webinar today, Case study: Match Funding with Flexibility.

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My name is Andrew Paolillo, and I'm the Director of Member Strategies and Solutions here at the Bank.

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And today we're going to discuss two types of advances that can be beneficial when looking to match fund or mitigate the interest-rate risk of any asset spread purchases, but also retain some of the flexibility that you may get with shorter funding

0:32

in terms of adjusting the amount or the pricing of funding as market conditions change. So those two advances that we're going to look at today are the Member-Option Advance, as well as the Symmetrical Prepayment Advance.

0:47

So to start off, we're going to look at a long horizon and give some perspective to the ebbs and flows of asset yields and the types of spreads attainable through match funding using advances.

1:01

So what we're looking at here is a chart. In blue,

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we have the ..., the yield on a 3 to 5-year investment grade corporate bond index.

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And in green, we have the spread from funding that corporate bond yield with a match term advance.

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So as we look at the ebbs and flows, and we see that in periods such as in the beginning of 2016, the spread widens out as softness … in the credit markets hit, and then it contracts over time. And then, we see periods like the, the latter half of 2018, where the spread begins to widen out again. And then it comes back down.

1:47

And then, most notably, … most recently, in March of 2020, at the onset of the COVID-19 pandemic, spreads went through the roof and nearly to 300 basis points …

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on that spread, as asset yields and asset spreads blew out much, much wider than where advances were being priced.

2:09

So, this gives you some perspective of … the transaction where interest-rate risk is mitigated, liquidity risk is mitigated, and the return is boiled down just to the credit spread component.

2:25

So, looking at something … in a shorter horizon that is prevalent in the market right now, is that the exceptional efforts taken by the Federal Reserve and the Quantitative Easing programs, is that it has calmed markets considerably.

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And one of the impacts of those actions is that the expectations for future interest-rate volatility have come down significantly and when we see volatility go lower

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That means that the cost for options to hedge against that volatility go lower as well.

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So, what we're looking at here is the spread on one of the advances that we're going to discuss today: the Member-Option Advance. And we're looking at the spread for that advance versus a comparable maturity

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Treasury. So we can see that the spreads did widen out as we got into the first part of this year when the pandemic did hit. But markets have calmed considerably since then.

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And … the spreads have contracted pretty sharply. And the bars here are meant to signify the maximum and minimum spreads that we have seen over the last year, as well as the average.

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So, we can see that, not only have we come well off the maximum spread levels that we saw in the first part of this year.

3:55

Well, we're very, very close to the minimum levels that we saw happen in the end of 2019.

4:07

So, you know, we mentioned earlier about how we're going to look at some examples, specifically how the Member-Option Advance and the Symmetrical Prepayment Advance can provide some value and some flexibility. So, here, we've just annotated along with the Classic Advance curve from 0 to 60 months, where the pricing falls in line for these two types of advances.

4:33

So, you can see the Symmetrical advance in the blue circles is priced at just two basis points above the comparable maturity long-term Classic Advance and then the Member-Option. You know, in the previous slide, we looked at the five-year maturity with a one-year lockout that's noted here as well as two other structures: a 5 year 3 years, so three years’ worth of lockout before the option kicks in, and then as well as the three-year one-year.

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So, to give a 30,000-foot overview of what these advances do is that the Member-Option, as the name implies, affords the member the ability to contract the advance to prepay it at the specified call dates, with no prepayment penalty.

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And the Symmetrical Prepayment Advance works in a similar way, in that you can prepay the advance at its approximate market value.

5:31

So if and when we're in a higher-rate scenario, there could be a potential gain received by the member for collapsing the advance.

5:44

We talk about the prepayment profile being a significant feature of the options afforded by these types of advance. So I just wanted to show, from a visual perspective, what those profiles look like and how they differ slightly from the Classic Advance. So, in the top left, we can see here the Classic Advance, where, as rates move lower, that prepayment fee becomes embedded into the advance.

6:16

In a higher rates scenario, there is no fee.

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So the Symmetrical, as we see in the bottom left, has a very similar profile in a down rate environment in that there's a fee to prepay the advance early. But in higher rates is where it differs from the Classic Advance in that not only are you not paying a fee, but you are potentially receiving a gain.

6:47

A Member-Option, on the other hand, has a similar profile to the Classic Advance in rising rate scenarios, but in down rate scenarios as opposed to the Classic where there is a fee to prepay the advance on the call dates. If you were to prepay the Member-Option Advance, there is no fee.

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So let's look at a, an actual example, a little bit of a case study here, and show some of the numbers … as well as the logic and the thought process for why the Member-Option is particularly attractive.

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So the question that we have to ask is, OK, well, we have this flexibility afforded as part of this advance.

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Why, and when would I use it?

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So in order for us to do an analysis, we need to look at a couple of different components of the curve here. So we want to look at, in the example we're going to use, here, is a five-year one-year Member-Option. So that means a five-year maturity.

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And then there's one-year of lockout.

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And then at that point, that's where that is … the first call date, where the member can elect to prepay the advance. So we're going to look at the 5-year 1-year priced at 117.

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And we're also gonna going to look at the five-year Classic and the four-year Classic priced at 79 and 68 basis points, respectively.

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So, what we have to do is, to, in order to answer that question of, how low do rates have to go, in order for it to make sense to exercise the call, we need to determine what the break-even rate is.

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And … the way that we can figure that out is, as you can see in the table on the left-hand side, the first step is to determine what we would have paid if we had taken a Classic for five years -- so, 79 basis points across five years.

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Well, we know when we take the Member-Option for the first year, we're paying 117 for that first year.

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So we subtract that 117 from the total cost of 395 that we would've paid for the Classic across the five years.

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And then that tells us, cumulatively, what our break-even cost is for those four years we have left to go on … the horizon. So that's 278.

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If we take that 278 and break it up, so that we can convert that to an annual number, we get to .695.

9:28 Now, what is interesting about this .695 is that that rate is above where the comparable maturity four-year rate is today of 68 basis points.

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So, what does that tell us?

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That is due to the roll down in the yield curve.

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So many of us are familiar with the concept of roll down, more from the asset side of the balance sheet where you can buy a particular asset at a certain yield and then as time passes

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it can be priced at a premium, even though rates, quote unquote didn't move that's because it's now being measured versus a shorter point on the curve.1

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So here's a case where the liability side benefits from, not just the shape of the curve, but the cheapness of the … option cost that we hadn't looked at a few slides prior, such that if nothing happens to the yield curve and we fast-forward one year, it would make sense to exercise this call.

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So you're paying less of a premium for a value that is closer to being in the money.

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So, around that, you know, let's look keep looking at this example

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and showing how if rates were to fall, how much of a benefit you might have from taking out this advance

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and capitalizing on the flexibility.

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It affords you from having the ability to call the advance but still having the protection of the mitigating the interest-rate risk from the longer final maturity. So in this example, we're gonna, stay with that same structure. The five-year one-year Member-Option Advance and we're gonna talk about a $50 million amount. And then we're going to assume that at the first call day, 12 months, prior 12 months after initiation, the rates have dropped 25 basis points.

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The decision is going to be made to exercise the call and then replace the funding with the going rate on the then four-year Classic.

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So it will now be a traditional match-funded transaction to maturity.

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So we know that if on the 50 million you had taken out a Classic on day one at a rate of 79 basis points,

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then the total interest cost would have been just [a] shade under $2 million across the five years.

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If we look at the second option of, if we had taken the five-year one-year Member-Option at 117, paid that rate for the first year and then exercised the call because rates have gone down, and then replaced it with a four-year Classic at 43 basis points,

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we see a total interest cost of 1.445 million.

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So, that works to 50 basis points, and we'll, we can see, is that the savings versus taking the Classic Advance, [is] a little more than half a million dollars, 21 basis points in percentage terms.

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And, the graph on the right-hand side shows us what the rolling funding cost was all along the way. So, in green, we can see … it's a flat 79 basis points. If we were to take the Classic, whereas the Member-Option, we start out paying a higher rate of 117.

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But as we exercise that call and benefit from the lower rate environment, that role in funding costs dropped rapidly.

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And then on about the 2.5-year mark, about halfway to that five-year maturity, it breached, crosses over, such that the savings start to kick in … on the total horizon.

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And you're paying less and less as time goes on as you get to that five-year horizon.13:39 So that was the Member-Option Advance. And now, we'll look at how the Symmetrical Prepayment Advance can work in a similar way, but in a different rate environment. So depending on what your outlook or your balance sheet conditions and needs may be,

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so,

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here, we'll take an example where we have a $25 million dollars borrowing and a five-year term.

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And for the Symmetrical, that would be at a rate of 81 basis points,

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just two basis points higher than where the current Classic rate is.

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So we fast-forward two years, and the yield curve is 200 basis points higher than where we are right now.

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So in a higher-rate environment, a liability that is at a lower rate than where the going rate is in the market is going to be worth less than … the original par amount.

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And again, we have to put on our liability hat, not our asset hat.

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Well, in that environment, a lower market value is actually a benefit because we're talking about the liability side of the balance sheet as opposed to the asset where a lower market value below par is not a good thing. It's a good thing for the liability side.

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So in this instance, if we were to exercise the advance where there is a potential gain to be taken off of the $25 million original par, you would only have to pay back $23,787,500. So, again, of a little more than $1.2 million dollars, or 4.85%.

15:29

So, like we did with the Member-Option, let's take a deeper dive into some of the arithmetic here and see how that actually translate into the total funding cost.

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So, we're going to operate with those same assumptions here where we take a $25 million-dollar, five-year Symmetrical at 81 basis points.

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We, two years forward, we're going to shock the yield curve by 200 basis points.

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And we're going to assume that we exercise the call. Well,

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if … that's all well and good to be able to take that gain, but we're going to assume that the balance sheet, or, a particular slice of the balance sheet still has a need to be funded, but there's still assets there that need to be funded.

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So we're going to assume that we're going to replace it with organic funding at 2%. Now, this could be funding of any shape and size.

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But for this example, we're going to assume that, whether it's a depository with deposits or an insurance company with internal cash generation, can replace it with a non-advance source. And we'll get to that a little bit more about that in a second.

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So, again, similar to the previous example, we can compare what the cost is versus if we had taken a Classic Advance and didn't have that flexibility afforded by the Symmetrical.

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For this Symmetrical, we're going to pay 81 basis points for the first two years, and then we're going to collapse the advance and take a gain of 4.85%.

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And then for the final three years, pay 2% or 6% cumulatively.

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So when we add all that up, the outflows of interest cost, and then the inflows of realizing the gain on the advance, it works out to 277.

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And then if we convert that to what it is over the five-year horizon, that works out to 55 basis points.

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When we look at the graph on the right-hand side, it's interesting because the light blue shows us just the outflows of the interest expense, right? We pay 81 basis points to start.

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But then when that 2% funding kicks in at the three-month mark, it starts to go higher and higher.

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And then, over, over the five years, it's a cost of 152. Well, why would we pay 152 when18:09 you know, we could have paid locked in 79 basis points, or 81 basis points rather, at the very beginning?

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Well, when we factor in the realized gain into the total funding cost, we can see that once we collapsed the gain of 485, that the member has more money coming in

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in terms of the realized gain then they have that they are paying out in terms of interest costs.

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So, at the 24-month mark, the total funding costs are actually negative. And it doesn't even get to a positive interest cost until about the 4.5 year,

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excuse me, about there [at the] 3.5-year mark.

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Because even replacing the funding at 2%, the impact of that realized gain helps to keep total funding costs low.

19:09

So, in this instance, when we replace the organic funding at 2%, the cost across the whole five years is 55 basis points.

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For illustrative purposes, if we wanted to get to a 0% total funding cost across the five years, and assuming the gain amount is going to be the same, then to solve for what that replacement funding rate would be, instead of 2%, it would be just about 1.07.

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So, in a scenario where the replacement funding can be at a cheaper source, then there is the possibility to even have negative funding cost across the five-year horizon.

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So, think about the great impact that that can have on the overall spread and income statement by entering in this type of transaction.

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So to wrap things up, we just want to look at the two products that we talked about today

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and summarize the benefits that they can afford to the member, as well as the relative value

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and the pricing afforded by some of the conditions that we're seeing here in the market. So

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you know, on the right-hand side, I think that tells the story right there. When we look at what the combined

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prepayment profile would be for a 50-50 blend of the Symmetrical Prepayment Advance, as well as the Member-Option Advance and comparing it versus the Classic Advance,

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so, we can see that in a down rate environment, that there's going to be less fee for that combination as opposed to the Classic Advance.

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And then if we get into a higher-rate environment, there is the potential to realize some gains and reduce the total funding cost, as opposed to the Classic Advance.

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So, we are out of time today. Please let us know if you have any questions, or if there's anything that we can be of help with.

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My contact information is here. Or feel free to reach out to your relationship manager and we'd be happy to have a discussion.

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Thank you very much and have a great day.

### Presentation Slides

View the slides for this webinar presentation here.