October 23, 2014
By Kevin Martin, Member Financial Strategies Manager
In the second quarter of 2014, net interest margin among community banks increased by eight basis points — a strong rebound from the nine basis points the margin shrank during the first quarter of the year.
Community bank yields on earning assets followed a similar trend during the same two periods. Influencing this trend was a growth in loans, which rose 8.8 percent over the last 12 months even as assets grew by only 6.9 percent.
Loan growth helps net interest margins but brings with it a different challenge — extension-risk associated with holding long-term, fixed-rate assets. If rates rise from current levels, thirty-year, fixed-rate mortgages may see their average lives extend from 8.5 years to 11 years as prepayments slow.
As rates rise, long-term Federal Home Loan Bank of Boston Classic advances can help protect net interest margin for members with long-term, fixed-rate assets. A combination of Classic advances with terms between one and 10 years can greatly reduce an institution's exposure to rising interest rates.
The Bank's Symmetrical Prepayment advance, which offers maturities for terms out to 20 years, offers another solution. While the advance has a minimum offering size of $10 million, smaller orders with identical terms will be aggregated and executed when they total $10 million.
The Symmetrical Prepayment advance is a fixed-rate advance similar to the Classic advance, though with an important distinction — it's the only advance the Bank offers where the Bank passes a gain through to the member if interest rates have risen since the advance was originated and the member prepays.
The Symmetrical Prepayment advance is usually priced two basis points above the Classic advance. The Bank cannot cancel the advance prior to final maturity, so the funding is yours until maturity provided it's not prepaid.
The special prepayment feature of a Symmetrical Prepayment advance taken down in early 2013 is worth a closer look. The advance was for five years and the interest-rate swap rate at the time was about one percent. At that time, three- and four-year interest-rate swap rates were 0.56 and 0.78 percent, respectively. Shortly after this advance was originated, interest rates began to increase, with three- and four-year interest-rate swap rates, as of mid-August, increasing 0.48 and 0.62 percent, respectively.
Having rolled down the curve and with about 3.5 years to maturity, the advance would be priced off the curve to yield about 1.30 percent, a gain of almost 90 basis points, or $9,000 per $1 million prepaid. The Bank would pass this through to the member, less a small fee, if the advance is prepaid.
If rates had fallen during this period and the member chose to prepay, the prepayment fee would be less than the fee associated with a Classic advance with identical terms.
As the likelihood of the Federal Reserve raising its benchmark rate by mid-to-late 2015 increases, the Symmetrical Prepayment advance is worth considering for long-term funding needs.