Case Study: Utilizing the SOFR-Indexed Advance - YouTube

0:00 Hello.

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

the Federal Home Loan Bank of Boston.

Thank you for joining us today for the second edition of our new case study series,

0:12 this one titled Utilizing the SOFR-Indexed

Advance.

0:17 So today what we're going to do is walk through

some of the details of how to use the SOFR-Indexed Advance and run some different scenarios and

see how this tool can be a useful way to check off a number of different boxes all at the

same time.

0:30 We're going to be funding at the short-end

of the curve, 0:32

we're going to try to mitigate some repricing risks, and most importantly, we're going to

save on interest costs and provide some relief to cost of funds ─ which is much needed

in this current environment.

0:44 So the first thing we're going to do is start

off by looking at a price comparison of the SOFR-Indexed Advance versus the traditional

short-term advance that many of you are familiar with, the Classic Advance.

In this particular instance, what we're comparing is the one-month Classic Advance ─

1:00 that's the blue line up top -- versus a three-month

maturity SOFR-Indexed Advance, that's the green line down on the bottom.

1:07 So where the Classic has a fixed rate and

is a bullet structure, the SOFR-Indexed Advance is a little bit different in that it's a floating-rate

advance 1:16

and the rate is going to adjust daily based off of the level of the SOFR Index plus a

spread that is predetermined and locked in at the initiation of the advance.

1:28 What we're looking at here is from the period

from May to August the rate on a one-month Classic Advance versus what the initial rate

would have been for a SOFR floater initiated on that very same day.

1:41 In a few slides, we'll get to how the rate

changes once you get past day one.

1:46 But what you can see here is that going back

over the last three months, 1:50

the SOFR floater has pretty consistently been a cheaper alternative versus the Classic Advance.

1:56 That differential at times has been pretty

substantial, as well.

2:00 It's averaged about 10 basis points, but it

has gotten as wide as 16 basis points.

2:06 And given that right now we're in a 0% interest-rate

world, that differential of 10 to 15 basis points can be pretty impactful, versus if

we were in a higher interest-rate environment.

2:20 So now that we've mentioned how there's two

components to the rate on the SOFR-Indexed Advance, you have the index level for SOFR,

which is going to adjust daily.

2:31 Then you have the spread, which is locked

in at initiation.

2:35 So while on the previous slide we saw that

the all-in rate for the three-month maturity SOFR floater, where it's been of late, here,

we're going to break it down and see how the individual components contribute to that all-in-

rate.

2:51 For example, if you look to the bottom left

in dark blue, that first data point right there is going to be what the index was for

SOFR.

3:01 back on May 13th: six basis points.

3:03 If we go to the top left, we'll see the first

data point in green there, 28 basis points, that was the spread for a new three-month

SOFR Advance that would have been initiated on that day.

3:16 So the all-in day one rate is going to be

the six basis points, plus 28 basis points, and we get to an all-in rate of 34 basis points.

3:27 If we move forward one week, the index moves

down to one basis point, and the spread on a new three- month SOFR

3:35 floater was 25 basis points back on that day

-- 25 plus one gets us to 26 basis points, and that was the all-in rate on that day.

3:45 And May 20th that was interesting because

that was the date that we had referenced on the previous slide where the differential

between the SOFR floater and the Classic Advance was at its widest of 16 basis points of difference.

3:58 And, in fact, we had an above average number

of members who were able … to take advantage of the SOFR floater on that day, recognizing

some of the relative value that was there.

4:08 So as you get past the first two weeks, you

begin to notice a little bit of a trend.

4:14 The SOFR Index, the blue line, starts to drift

a little bit higher from that low of one basis point, up towards 13 basis points in July

before sailing back into the nine-basis points range.

4:27 But balancing that out was the fact that spreads

for new advances kept tightening, so as the index was going a little bit higher, spreads

on new advances were tightening so they had a little bit of an offsetting effect.

4:44 So quickly, it's important to emphasize why

tightening spreads and what that opportunity presents is something to focus on.

So advance spreads, especially on the short-term, tend to be relatively stable over time, but

they do fluctuate.

So the band that they float in tends to be very narrow, usually within just five basis

points or so, 5:09

but in periods of high volatility, much, like we saw back in March of 2020, they can occasionally

move much more than that.

That's that spike in the green line towards the right-hand side of the screen.

5:22 So while those shifts were pretty modest relative

to some of the extreme moves that we saw in other financial instruments during that time,

(both asset and liability), it does underscore the importance of spreads and the impact of

repricing frequency when you're talking about funding management.

5:46 Earlier we had pointed out how the SOFR floater

differs from the Classic Advance in that it has an adjustable rate.

5:54 So what we want to do now is look at a real-life

example and see how taking a SOFR Floater back in May would have fared on a three-month

horizon.

6:04 And we're going to compare it versus a strategy

of taking a one-month Classic Advance and rolling it over for that same period of three

months – which is that rolling short-term advances is a strategy that many members utilize

as it fits in well to the overall balance sheet approach.

6:23 So the chart on the left, if you look at the

green dots, those are the actual daily rates that were accrued in the

6:33 SOFR floater starting from back in May.

The spread on that advance was assumed to be plus 28.

6:40 And we see those three solitary blue dots

on the top, and those are the rates that you would have paid every month to rollover the

Classic Advance.

6:51 So, you can see the first data point there,

there was a nine-basis point differential, so the SOFR- Index Advance was cheaper than

the Classic Advance by nine basis points.

7:05 So, as time started to pass, the accruals,

as the index rate moved down, as we saw a slide or two ago, to a low of 29 basis points.

7:17 But then as the SOFR index started to drift

up, so did the accrual rate on the SOFR-Indexed Advance.

7:23 And it's interesting to point out in the middle

of July, as the accrual rate rose, it never even reached the rate that was being paid

on any of the competing one-month Classic Advances.

So, it shows you that margin of safety 7:43

that was available on day one.

7:46 So, on the left-hand side, we have the daily

rates, the actual rates paid on the right-hand side -now, this is just going to be the rolling

average cost for that strategy over time.

7:57 So what we can see, we can see that effect

that even though the SOFR-Indexed Advance cost went up as the accruals went up, we can

see when we get to the end of the three-month period that on the rolling Classic strategy,

the blue line up top, the weighted average cost went up to be 43 basis points, whereas

the SOFR-Indexed Advance proved to be a cheaper option ─ seven basis points less at 36 basis

points.

8:27 So, this is all well and good, but, you know,

that was an example of what happened from May to August.

How do we look forward?

How do we see what could happen under a couple of different scenarios?

So, what we’re going to do is look at this same strategy comparison − we're going to

compare a three-month SOFR- 8:45

Indexed Advance, versus a strategy of rolling one-month Classics for a period of three months.

8:54 So, here, we're going to undertake a couple

of stress tests.

In test number one, we're going to jump right in with a pretty rigorous test

9:04 and we're going to assume that the SOFR Index

goes higher to 25 basis points, the top end of the Fed funds range at present,

9:16 and that's going to occur over the span of

the first month.

9:19 And while this is happening, we're going to

assume that that Treasury bill rates, (which are a key determinant of Classic Advance rates),

we're going to assume that T-bill rates are unchanged.

9:32 Aside from those rate changes or the unchanged

in the case of the T-bill, we're going to apply some further rigor to this test and

assume that Classic Advance spreads will actually tighten by five basis points.

9:44 So, when we look at the month by month, interest

cost as well as the accumulated total cost, what we see is that the SOFR-Indexed Advance

has an advantage in that first month, coming in slightly less, then the first month for

the Classic Advance.

10:01 But in months two and three, the Classic Advance

outpaced the SOFR-Indexed Advance because the SOFR Index has gone higher, and the advance

spreads have allowed the Classic Advance cost to tighten.

10:15 And we can see all the way to the right, that

the strategy of rolling one-month Classic Advances under this stress test proved to

be a cheaper option by about six basis points --38 basis points versus 40.

10:30 For test number two, we're going to go with

something similar, but we're probably a little bit more realistic, in that we're going to

keep ramping SOFR up to 25 basis points, or we're going to do it over the period of three

months, 10:44

and we're going to have Treasury bills move in lockstep with SOFR so they're going to

bump up a little bit higher as well.

10:55 We're going to keep that advance tightening

in there as well.

11:00 So what we see here is that, once again, the

SOFR-Indexed Advance gets the benefit in that first month by producing a cheaper alternative

by seven basis points, and then as we get to each of the next two months, that

11:17 gap between the SOFR-Indexed Advance and the

rolling Classic strategy -- the SOFR is a cheaper alternative in each one of those months

as well.

11:26 And then when we look at the total cost, the

SOFR comes out as a cheaper option by four basis points.

11:37 OK, so test 1 and 2, were traditional stress

tests where we asked the question: “How can this go against us?”

11:45 And, you know, as a floating-rate liability,

it's intuitive to think that the risk is that if rates go higher, to some extent, that's

going to have a negative impact.

So with test number three, we're going to look at things a little bit differently, and

say, how can this work out well for us.

12:04 So, as we look at this test, we're going to

assume that SOFR 12:08

Index goes from its current level down to 0%, and we're going to (over the course of

three months), we're going to assume that T-bills do the same thing --

12:17 they're going to move in lockstep all the

way down to 0% 12:20

And because that type of market movement, you know, typically will signal some stress

in the markets with that flight to quality, we're going to widen Classic Advance spreads

by five basis points in this instance.

12:36 So what we have here is that the total cost

differential between the SOFR floater and the rolling Classic strategy is significantly

wider than what we saw in test 1 and 2 and it's sharply in the member's favor.

12:49 So the total cost for the SOFR strategy is

26 basis points compared to 41 basis points for the rolling Classic strategy.

12:58 This significant interest cost savings really

highlights the value of being able to lock in that spread.

So, remember, we talked about the two components of the SOFR-Index Advance rate

13:12 So you retain the ability to reprice as market

interest rates go lower and down to 0% in this case,

13:21 but the value of the locked-in spread doesn't

expose you to the risk of a widening on any one particular day --

13:30 the day when your advance happens to come

up for renewal.

So think back to that spread fluctuations chart from a few slides ago,

13:40 and we saw that volatility, and we saw that

widening occur at the onset of the pandemic, back in March.

13:46 And if you had funding due to be rolled over

on that day, you were exposed to a significant widening in the levels of the funding versus

if it was a week prior, two weeks prior, or even as conditions calmed down one to two

weeks after that period.

14:09 So to wrap things up here, hopefully you were

able to get an idea on how the mechanics of the SOFR-Indexed Advance works and also how

some of the current market conditions present some opportunity for some pretty significant

cost savings versus some other short-term advanced solutions.

14:26 So, importantly, also, we saw not just how

it looked in a snapshot today, but how the different strategies performed under a range

of scenarios, testing the exposure to both rising and falling rates, as well as widening

and tightening advance spreads.

14:45 So, I think that the net result here is that

it shows us it can be a pretty useful tool in the toolkit

14:51 and most especially in these conditions, where

margin is under pressure from both sides of the balance sheet, and every basis point counts

that much more.

15:01 So, you know, from an operational standpoint,

you may have noticed from the daily rate emails that we've been offering advance specials

on the three-month maturity SOFR-Indexed Advance every week ─ typically, on Thursday mornings

─ but the advance is available every day of the week and it's not just limited to that

three-month maturity.

15:22 Longer maturity offerings are available such

as one, two, or three years, 15:30

so feel free to reach out to us here in the strategies group, or call the Money Desk

15:34 and we'd be happy to price out any structure

that you may be thinking about or just want to keep the tires on the levels, we'd be happy

to answer any questions that you may have.

15:47 That is all for our presentation today.

15:50 Hopefully, you found some value and you took

away something that may be useful as you go through your balance sheet management process

in this unique and challenging time.

16:00 I'll point out that this recording, as well

as the PDF version of the slides, are available on our website, along with the other case

studies, webinars, and articles, and other types of content that we have out there.

So, if you have any questions, please feel free to reach out to me or your relationship

manager.

We'd be happy to help out and answer any questions you may have.

Thank you and have a great day.