The putable advance has been one of the most popular credit products over the past two years. The putable differs from other fixed term advances because the FHLBI retains an option to convert it to a three-month LIBOR adjustable advance prior to maturity on pre-specified put dates. By selling the FHLBI this option, the member pays a lower rate for the funding than on a comparable fixed term advance.

The low price is popular with everyone. But whether or not adding the option risk to a member’s balance sheet is a wise move depends on the composition of that balance sheet. This Insider explains an appropriate use of the putable advance by showing how a liability-sensitive bank, one that is negatively gapped, can improve its risk return trade-off.

In a liability sensitive institution, net interest income declines as interest rates rise and increases as rates fall. If management wishes to reduce this interest rate sensitivity, the typical strategies are either to borrow longer-term funding or to sell longer-term assets. Implementing either strategy will usually reduce the bank’s current profitability in exchange for risk reduction. Long-term funding is more costly than short-term deposits. Selling long-term loans and reinvesting in shorter-term assets will normally lower asset yields.

Some banks hesitate to extend the maturities on liabilities because of the negative impact on current profitability. In particular, banks that already consider their current earnings insufficient may not view this strategy as a viable option. The putable advance may provide a more cost-effective way of extending the maturities on liabilities.

In using the putable advance to lower interest rate risk, the most important characteristic is the first put date. If interest rates rise, the maturity of the putable advance will effectively be the first put date. Banks that are heavily funded with short-term liabilities can extend maturities with the putable advance by using put dates one year or longer.

While the putable advance may be cheaper than other longer term funding as a hedge against rising interest rates, it does not come without cost. If interest rates fall, the putable advance extends at a time when its rate is above market. However, since the net income of a liability sensitive bank improves as interest rates fall, the higher cost of the putable advance will be mitigated in later years.

Let’s consider the simple example of Liability Sensitive Bank (LSB). Assume the bank expects to earn 150 basis points in spread over the next five years if interest rates remain constant. If interest rates rise 200 basis points, LSB’s spread will narrow by 30 basis points to 120 for three years before adjusting back to the 150 basis point spread. On the other hand, if interest rates decline 200 basis points, LSB’s spread will widen by 30 basis points to 180 for three years, and then adjust back down to 150 basis points. The potential volatility in spread over these scenarios is illustrated in the chart below.

Let’s assume that LSB’s management is considering two strategies for reducing interest rate risk. The first strategy is to extend 15 percent of its three-month liabilities (currently costing 5.0 percent) to three years. This maturity extension can be achieved by converting the three-month liability to a three-year bullet advance at 5.92 percent. As an alternative, LSB is considering extending three-month liabilities using a five-year putable advance with a three-year lockout at 5.58 percent. The bullet advance option reduces LSB’s overall spread by 14 basis points over the next three years before adjusting back to 150 basis points. The putable advance option reduces LSB’s spread by only 9 basis points over the next three years before adjusting back to 150 basis points, assuming no change in rates.

Either strategy reduces the interest rate sensitivity of LSB. The bullet advance strategy maintains the net interest spread whether interest rates rise or fall by 200 basis points. The putable advance strategy also maintains the net interest spread when interest rates rise 200 basis points, and adds a 5 basis point savings. When interest rates fall 200 basis points, the net interest spread is maintained during the first three years, but will not adjust back to 150 basis points in years four and five. This difference when rates go down is shown in the chart above. Instead, the putable spread will remain at 141 basis points. The 5 basis point savings in the first three years will cost 9 basis points in the last two years. This down rate scenario is part of the cost of reducing the interest rate sensitivity using the putable advance strategy.

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