Case Study: Breakeven Rate Analysis

Hi, everyone. My name is Andrew Paolillo, Director of Member Strategies, and Solutions here at the bank. Thank you for joining us today for our latest case study, where we will look at how to find relative value with breakeven rate analysis.

So, let’s start out by looking at the wild ride that the yield curve has been on over these last few months.

So, in the graph on the left-hand side, we can see the shape of the classic advance curve in green as of October 31st, 2023, and then, in blue, where the classic advance curve was as of the end of January.

And we can see the curve was higher and less inverted in October versus where we were in January of 2024.

And the driver there was the market expectations changing.

And the much-anticipated potential for the Federal Reserve to cut short-term rates after this incredibly historic hiking cycle that we’ve been through these last 18 to 24 months.

So, we saw the curve start to move down, and we can see that, as evidenced by the table on the right-hand side when we look at the steepness of the yield curve.

So, the relationship between a short point and a longer point, that spread has decreased considerably in the in the various different combinations.

So, whether it was already inverted, it got more inverted, and we’ll get into, in a few moments here, some of the implications of what that inverted curve is telling us.

So, you can see the question up top here, which is a very important, relevant question in these times, as when we think about incremental funding, do we look to fund short, or do we fund long?

And there’s a number of factors, certainly that play into that, and we can bucket it in two ways, and we’ll look at it that right now.

You know, the first component would be on the right-hand side, in green; here, more of the interest-rate risk, interest-cost side of things, and how will the total cost of the strategy fair whether we’re funding short or long versus an alternative approach.

And, you know, a couple of the considerations that we have to factor in our what’s priced into the market and the yield curve right now. And we’ll follow up with that on the on the following slides.

But then there’s also the component of what is the potential for those market expectations to change over time.

Then, another thing that we have to bring into play here is, you know, from a total balance sheet perspective, what does our interest rate risk profile and what does the balance sheet need?

Both in a current snapshot, but over time, and in various different changing rates scenarios. And that’s certainly something that we have seen over these last few years, as many members have expressed to us that where they were previously assets sensitive, the changing dynamics on the balance sheet and with market interest rates have flipped them to a liability-sensitive or more neutral rate positioning.

Now, on the left-hand side, you know, it talks more about the liquidity aspect of things. So, we less about where the cost or the value is in terms of what the yield curve is offering us.

So, really, the question that needs to be asked is, how long will I need this wholesale funding? Yes. I need it right now, and I might have some motivation to hedge interest rate risk.

But, you know, some of the considerations that we need to think about is what do we think deposit growth is going to be in with this rapid rise in rates over the last 12 to 24 months, the environment for the gathering and the retention of deposits has been as challenging as it’s been in many, many decades. You know, forget a shorter period but, really over the very, very long term.

So, the current environment is right now, and we hear that from members in terms of deposit growth, budgeting, forecasts, and expectations.

It’s very challenging to see or to expect ample amounts of deposits to come in over the near term, at least, where, with rates where they are right now, so that, you know, that would suggest that the need for wholesale funding is going to continue for a while.

The other side of the coin is the expectations for loan growth.

And, you know, as weak as deposit growth has been, over the last few quarters, loan growth has been exceptional, and it’s settled into the mid-single digits for many, these last few quarters, which is down from double digits for most, going back into 23 and 22.

But, you know, conditions are still ripe. And the demand from what we’re seeing and hearing from members, loan growth is still robust.

But, you know, the decision has to be made about how much more growth there is in this inverted yield curve environment. Considering capital ratios, how much do we want to continue to move along there?

The other component of the liquidity needs, or the potential liquidity needs, is how much can organically come back to us from asset prepays and paydowns.

Now, normally, you know, we think back to 2019, when the yield curve had a similar shape to what it has right now.

Then, the need for wholesale funding was less than what it is right now, and the reason for that is all about the path of interest rates. In that period in 2019, when the yield curve inverted, we saw an exceptionally high level of prepayments on mortgage assets, whether it’s investments or mortgage loans on the books, because of where rates had been over the near history versus where they got to in 2019. So, for the incremental loan growth, there was the opportunity to have that funded from Asset Cashflows.

Now, we’re in a little bit different environment, where we have.

A large portion of the mortgage book is that much, much lower rates than where market rates are to the tune of 200 to 400 basis points below. So, it would really take a substantial decline and intermediate-term rates to see a meaningful amount of cash flow acceleration come from the existing assets that would be there to fund, possibly, further balance sheet needs.

So, what we’ll do here is we’ll look at three different scenarios and three different ideas, where we’re debating between a couple of different funding strategies. And, you know, we’re going to look at some scenarios where, what might happen over the near term, in terms of moves and interest rates. And it comes back to the title of this case study, Finding the breakeven rates.

So, when we do this type of analysis, that we’ll see in a little bit, we can compare two different strategies and look at the tradeoff between what the cost savings, maybe initially, but how much would rates have to go against us in whatever direction, depending on the particular strategy. How much would rates have to move in order for the economics to flip and one strategy to look better than the other strategy? And that helps us inform the decision that we ultimately want to make if the breakeven rate and the amount of cushion that we have is sufficient for your risk tolerance.

So, the first thing we’ll look at here is debating between taking out a one-year advance versus rolling, short term. In this case, we’ll use three-month advances for a period of 12 months.

So, one common refrain that we hear from members an awful lot lately is that while we’re staying short on our funding because we expect rates to go down in the short term. And, you know, certainly, we’ve referenced that before, we can look at the, the probabilities for rate cuts over the coming Fed meetings, and certainly, many, many, market, participants and prognosticators, are expecting short-term rates to go down.

Now, what is important to remember here is that the yield curve is just simply a pricing mechanism. So, you know, there’s not many or any really free lunches when we’re talking about interest rates.

So, when we have an inverted curve, very simply, what does that telling us, when we see the yield curve invert; when we see intermediate or long-term rates move below short-term rates, the market tells is that the expectation is that short rates will be lower in the future.

So, just to summarize, when we look at a 12-month rate that is lower than the three-month rate, it is being priced in the short-term rate being lower in the future than it is today. So, let’s look at this example.

So, as well as we pulled these rates, recently, the three-month rate was at 550 compared to the 12-month rate at 482.

So, the way yield curve arithmetic works is that there’s an implied rate for every step along the way, if we were to borrow a three months and replace borrow again for three months and then replace all the way out to a term of 12 months, and it should be equivalent to the 482, because that is what the market is building into their expectations today.

So, in this example here, what’s implied for months four, five six from the shape of the current yield curve is that that three-month rate, three months into the future is lower. It’s at 514 today.

For that next period of three months.

Months, 7, 8, 9, it’s even further down, 451, and then for those last months, 10, 11, and 12, it’s that much further down.

So, when we think about borrowing at 482 today versus borrowing at 550 and then having the uncertainty of where rates may be going in the future, what it nets out to, is that the implied rate for that month, 10, 11, 12, has over 130 basis points below the current level.

So, like we said before, the expectation of lower short-term rates is priced into the yield curve when we see this type of inversion.

So any decision making that you’d want to have is going to be predicated off of the fact that do I think the expectations have swung too far in one direction or the other.

So if you think that some of the rate cut euphoria is overblown, then it would behoove you to look to nudge out the yield curve and take advantage of what’s being priced in before any of that upward movement or normalization occurs.

Now, let’s look at a second example where, you know, we want a little more flexibility that, if not, have rates go back up, but if they do accelerate to the downside here.

So, you know, a popular strategy for many members is to utilize our Daily Cash Manager Advance or overnight advance, which provides great flexibility late in the day to get overnight borrowings to manage very short-term liquidity needs. So, we also have a floating rate advance called the SOFR-Index Advance. That provides many of those same repricing benefits but affords you some of the benefits of the longer-term liquidity, and we’ll get into the, you know, the spread risk benefits of the floating rate advances as well.

So you can see here in the top left Daily Cash Manager was recently priced at 550, and we can look at some of the examples for the SOFR-Index Advance at various short terms three, six, and nine months.

And you know, the way that all-in rate is derived is it starts with the SOFR-Index at 532, and then adds the spread for the advance, in this case, 18 basis points for the one, three, and six month and then 20 basis points for the nine-month advance.

And you can see when you add those up, the day-one rate is equivalent for the one month, three month in six months SOFR relative to the Daily Cash Manager.

Now, you may be asking, Why would I do this? So there’s a couple of benefits.

You know, one thing that, you know, many folks tell us is that Daily Cash Manager, while convenient, can be operationally burdensome in terms of consistently having to come in every day and refund whatever portion amount that you may need. So the SOFR-Index Advance would afford you that ability, that it’s going to price and move as short-term rates go. So if SOFR went from 532 unexpectedly to 3%, well then you would move down the 200 basis points right along with that.

The other component is the spread risk that we talked about, oftentimes, in periods of stress, you know, having to constantly replace and replace and reprice the advance….we do see spreads widen out occasionally. So. But, the way the floating rate advance works is that the index may vary, but the spread that you lock into at initiation is fixed for the life of the advance.

So, you have, you know, some risk mitigation there.

So, the graphic at the bottom just looks at an example of a laddered funding strategy, where you may have a portion that you’re funding from a daily cash manager and looking to utilize some of those floating rate advances. We’re pushing them out across a period of one to nine months. And, you know, it’s often prudent to, you know, keep some portion very, very short overnight because you’re, if you’re managing your liquidity, you want to have that flexibility to give it back if you have deposited inflows or asset cash flows, or whatever the case may be. But you still get the liquidity benefits of having the longer-term advances on the books. But your repricing is going to be exactly the same.

You’re going to get the benefits if rates are turned down. You’ll be able to seamlessly and efficiently reduce your interest expense.

Another popular strategy of late for many members in this inverted yield curve environment where interest rate volatility continues to persist at very high levels is using our HLB-Option Advance. And that, if you’re not familiar, is a puttable advance, where the rate that you’re able to capture is, it can be below the Classic Advance curve. And that’s because you’re selling the options of the Federal Home Loan Bank of Boston to be able to take the advance back at pre-determined intervals. So, it’s very similar to make the comparison on the asset side.

You know, much like when you debate buying a Treasury bond versus a mortgage-backed security, and there’s a reason why there’s more spread available in the mortgage-backed security versus the Treasury. Because you’re able to, you’re taking that the uncertainty of the cash flows, right? It may be a five-year, average life, and maybe a seven-year average life, and maybe a three-year average life.

So, for taking on that variable cash flow risk, you’re getting compensated by the extra spread. So, as we flip it back over to the liability side, that’s why you’re able to borrow at lower rates than what you can on the classic advance curve.

So, here we are, looking at an example on the left-hand side, where an HLB-Option with a three-year maturity and one year of lockout period is priced at 391, and we’re comparing that to the one-year Classic Advance at 498. So right off the bat, in that first year, you’re capturing over one hundred basis points of savings.

But because with the Classic Advance, at the end of one year, the advance is done, and you can replay so you cannot replace, you can do whatever you need.

But with the HLB-Option Advance, it may get exercised or may continue to stay on the books.

So we can do the arithmetic and say how far would rates have to go down for the advance, the cost savings advantage for the HLB-Option to move in favor of the Classic and replace strategy?

So you can see the dashed blue line on the bottom.

So for assuming that the if we were to stress test and, say, the HLB-Option did extend fully out to maturity, well, then the replacement rate would have to be 338 in this case.

So, and that rate can come from, it can come from the marginal short-term borrowing rate.

So that is over 220 basis points right now, versus that rate. So there’s an awful lot of cushion for rates to go down for the economics is still in your favor. It could also come from deposits or any other type of funding.

As well, along the right-hand side, you can see some of the nuances with whatever horizon that we look at. So I just I just mentioned that in that stress test, we’re assuming that the HLB-Option fully extends out to three years. While because of the quarterly put option that is embedded into the advance, it may get called at the 12-month mark. After the lockout, you may get called every quarter thereafter, 15, 18, 21, 24 months, and so on.

So, again, we can calculate the breakeven at all of those different intervals to see where we would stand; so the shorter the horizon, the lower the breakeven rate would have to be, and the more cushion that you’re afforded by capturing those cost savings right now.

So, in this example here, if the advance were to get exercised at the 24-month mark a year before the final maturity, well, then the breakeven would have to be 284 for that incremental period after the lockout again versus where rates are right now. That is a considerable amount of cushion for rates to move down. And again, you’re booking a fair amount of savings for year one.

​So, that brings us to the end of the case study. Hopefully, you found this exercise of being able to look at the breakeven rates useful, as always. If there’s anything that we can do to help with any of these analytics, and the thought process as you debate, you know, which direction you go on your advance usage, we are here to be of assistance. So, please feel free to reach out to your relationship manager, or to me directly, and we’ll be happy to have our conversation and support you in any way that we can.

​Thank you very much, and have a great day.