Strategies for a Steeper Yield Curve

There’s no doubt that depository institutions experienced significant shifts in their balance sheets in 2020. As both consumers and businesses reduced expenditures and built up their own balance sheet liquidity, customer loan demand was inconsistent. As the chart below shows, the median loan-to-asset ratio for FHLBank Boston depository members declined sharply year over year.

This contraction in loans was paired with historic growth in deposits, leaving banks and credit unions with the challenge of increased funds to deploy with fewer places to place them. Compounding the issue was the fact that yields were low, the curve was flat, and spreads (on both loans and investments) were narrow due to the excess liquidity in the financial system. Even where there were pockets of loan demand or investment supply, the risk/return profile was less favorable than what many have grown accustomed to.

But recent movements in markets have started to create a more palatable environment for financial institutions. Vaccine progress and signs of economic recovery have led to longer term rates pushing higher, which has created more appealing economics for those who lend and invest beyond the short end of the curve.  

The chart below shows the movements in the two-year versus the 10-year Treasury curve steepness as compared to an equal-weighted index of all publicly traded banks that are FHLBank Boston members. As the yield curve has gotten steeper, bank stocks have performed exceptionally because investors are seeing improving potential in the short- and long-term earnings prospects for the industry.

Looking at other parts of the curve, one can see why a steeper curve is looked upon favorably. Since the beginning of the year, intermediate-term rates (as shown by the five-year Treasury yield) have seen a considerable move higher, which is supportive of asset yields. Meanwhile, shorter-term rates (as shown by one- and three-year Treasury yields) have lagged and not experienced the same type of increase. This part of the curve, as well as inside of one year, is more closely aligned with depository funding costs.

This is a welcome reprieve for balance sheet managers who have been holding elevated levels of cash. The prospect for deploying that cash and earning spread looks more favorable than it did just a few months prior. Additionally, balance sheet growth looks more attractive for those able to position both assets and new funding strategically in order to take advantage of the increased slope of the yield curve.

FHLBank Boston offers discounted advances that support a variety of economic development initiatives. Members can access up to $35 million of discounted funding per year through the Community Development Advance (CDA) and $15 million of discounted funding per year through Community Development Advance Extra (CDA Extra) if certain qualifications are met. Contact your relationship manager if you have questions on the application process and requirements. 

As the chart below highlights, CDA and CDA Extra funding offers steep discounts versus Classic Advances. For example, CDA Extra priced at 0.51% for the three-year term is 26 basis points below the comparable maturity Classic Advance. If your balance sheet needs suggest mitigating interest-rate risk as an appropriate tactic, then CDA and CDA Extra can offer a cost-effective way to accomplish that.

In a recent case study, we looked at how the LIBOR transition has impacted a balance sheet hedging strategy that some members have traditionally used. As the market shifts away from LIBOR-based instruments and toward those based on SOFR or Fed Funds, the SOFR-Indexed Advance can serve as a natural funding vehicle to meet the key needs of lowering interest expense, managing interest-rate risk, improving liquidity, and meeting hedge effectiveness. 

The table below compares three strategies: a pay fixed three-year SOFR swap funded with a one-year SOFR-Indexed Advance; a pay fixed three-year, one-month LIBOR swap funded with a one-month Classic Advance; and a three-year Classic Advance. All three strategies produce the same three years of term rate protection, but the SOFR strategy produces the lowest all-in cost, while providing 12 months of term liquidity protection, which is an improvement and less of an operational burden versus the LIBOR strategy.

The 12-month tenor of the Classic Advance curve typically offers narrow spreads versus the comparable maturity Treasury yield. With the short end of the yield curve so close to zero, the repricing benefits of shorter maturities are reduced. If a member is inclined to trade off some of the interest-rate risk mitigation of extending to further support net interest margin, then the 12-month Classic offers value.

The chart below shows how a strategy of borrowing at the 12-month term (especially when using the Advance Renewal Discount Program) can be more advantageous than rolling three-month advances for a similar time horizon. With the 12-month rate below the three-month rate, we can calculate what the three-month rates would need to be for the remaining three-month periods in order to produce a similar total cost to borrowing at 12 months today. Short-term rates would have to move significantly below current levels for the rolling strategy to outperform.

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.