Why a Capped Floater is Right for You

posted on Monday, November 13, 2017 in Advances

Advantages of the Capped Floaters

During times when interest rates are expected to increase significantly, it can be important to secure both duration and cost certain funding. Quite often, when an institution does decide to take the step to lock in funding to protect against a rise in rates, fixed rate funding is the first choice. And why wouldn't it be? If your institution is worried about rising rates, a fixed rate product protects against just that.

The Federal Home Loan Bank of Des Moines (FHLB Des Moines), however, would like to make the case for considering a variable rate advance. At first glance, this seems counterintuitive and it certainly could be if structured as a standard variable rate advance. However, with a Capped LIBOR Indexed Advance (Capped Floater) you can secure variable rate funding that also protects against a dramatic increase in rates. Additionally, unlike a fixed rate advance, if rates were to decrease, the variable rate allows you to reap the benefits of the downward movements.

The Capped Floater is a great product to consider for any floating rate product you may offer. However, it can also be a great tool to consider for any float to fixed rate product that you offer. When issuing float to fixed rate commercial real estate or multifamily loans, the Capped Floater gives you the ability to fund the floating rate portion with a floating rate advance, while setting the fixed rate portion at a spread to the cap rate. This allows you to lock in a net interest spread during the floating rate period and also set a worst-case minimum spread on the fixed rate portion with the cap rate. Additionally, if your loan product includes an interest rate floor, you now have protection on both sides. If rates go down to the point that the loan hits the interest rate floor, the advance rate will continue to move lower.

The Capped Floater allows you to take a LIBOR indexed advance and apply an interest rate cap to the LIBOR rate; either 1-month or 3-month LIBOR. The premium is dependent on three different aspects: 1) the term of the advance, 2) the LIBOR index chosen, and 3) the cap strike rate on the LIBOR index chosen. The cap strike rate is the upper bound limit you set for the LIBOR index of your choosing. For example, if you choose a cap strike rate of 3.0%, LIBOR will cap out at 3.0%. That means the maximum advance rate would be 3.0% plus the spread to LIBOR that was locked in at origination of the advance. We can look at the three-year, 3M LIBOR Capped Floater as an example in Table 1.

Table 1: Calculation of a Capped LIBOR Index Advance Rate

Term LIBOR Index Spread to LIBOR LIBOR Rate Initial Rate Cap Strike Maximum Rate
3 Years 3 Month 0.17% 1.36% 1.53% 3.00% 3.17%

Table 2: Capped LIBOR Index Advance Rate in Different Rate Scenarios

Term LIBOR Index Spread to LIBOR LIBOR Rate Cap Strike Cap Rate Advance Rate
3 Years 3 Month 0.17% 1.36% 3.00% 3.17% 1.53%
3 Years 3 Month 0.17% 2.36% 3.00% 3.17% 2.53%
3 Years 3 Month 0.17% 3.36% 3.00% 3.17% 3.17%
3 Years 3 Month 0.17% 4.36% 3.00% 3.17% 3.17%
3 Years 3 Month 0.17% 5.36% 3.00% 3.17% 3.17%

Now, what is the reason to consider using a Capped Floater instead of a bullet advance? Table 3 provides some examples of various Capped Floater rates, this time with a cap strike of 4.00%, and what the corresponding Bullet Advance fixed rate would be. As expected, in every case, the Capped Floater advance rate is the cheaper option at settlement due to the risk associated with a floating rate instrument.

Table 3: Rate Comparison between Capped LIBOR Indexed Advances and Bullet Advances

Term LIBOR Index Spread to LIBOR LIBOR Rate Initial Rate Cap Strike Maximum Rate Bullet Advance Rate Initial Delta Floating/ Fixed Rate
1 Year 1 Month 0.18% 1.24% 1.42% 4.00% 4.18% 1.70% -0.28%
1 Year 3 Month 0.11% 1.36% 1.47% 4.00% 4.11% 1.70% -0.23%
3 Years 1 Month 0.24% 1.24% 1.48% 4.00% 4.24% 2.06% -0.58%
3 Years 3 Month 0.15% 1.36% 1.51% 4.00% 4.15% 2.06% -0.55%
5 Years 1 Month 0.42% 1.24% 1.66% 4.00% 4.42% 2.36% -0.70%
5 Years 3 Month 0.34% 1.36% 1.70% 4.00% 4.34% 2.36% -0.66%
7 Years 1 Month 0.62% 1.24% 1.86% 4.00% 4.62% 2.64% -0.78%
7 Years 3 Month 0.54% 1.36% 1.90% 4.00% 4.54% 2.64% -0.74%
10 Years 1 Month 0.88% 1.24% 2.12% 4.00% 4.88% 2.97% -0.85%
10 Years 3 Month 0.81% 1.36% 2.17% 4.00% 4.81% 2.97% -0.80%

The decision to use a Capped Floater or a Bullet Advance boils down to your institution's outlook on interest rates. Everything from the direction, severity and timing of rate movements must be considered when analyzing the decision on whether or not to use a Capped Floater in lieu of a Bullet Advance. It is important to note that since the index rate is capped, the risk associated with rates increasing is limited and known. If your advance has a cap strike of 3.00% and 3M LIBOR increases by 400 basis points, it will not impact you as severely since, in the example provided above, LIBOR is capped at 3.00%. That means, at the time of this printing, the maximum rate increase of a 3M Capped Floater would be 185 basis points, the different between the strike rate and current 3M LIBOR.

Now let's analyze a few hypothetical rate movement scenarios to help illustrate possible outcomes of executing a Capped Floater. Remember, as discussed, both timing and severity of rate movements play an important role when trying to determine if you are better off with a fixed or variable rate advance. Additionally, for this exercise, we will ignore downward rate movements since the Capped Floater advance clearly will be more valuable in those situations. For these scenarios, we will continue to use a three-year, 3M LIBOR structure.

Rate Scenario #1

Settlement Reset 1 Reset 2 Reset 3 Reset 4 Reset 5 Reset 6 Reset 7 Reset 8 Reset 9 Reset 10 Reset 11 Avg Rate
1.53% 1.63% 1.78% 1.78% 2.03% 2.13% 2.13% 2.23% 2.33% 2.33% 2.43% 2.43% 2.06%

In this first scenario, 3M LIBOR increases 90 basis points over the duration of the advance, settling at 2.43% for the last reset. Coincidentally, the average rate would be 2.06%, the same as a three-year bullet advance.

Rate Scenario #2

Settlement Reset 1 Reset 2 Reset 3 Reset 4 Reset 5 Reset 6 Reset 7 Reset 8 Reset 9 Reset 10 Reset 11 Avg Rate
1.53% 1.78% 1.88% 1.93% 1.98% 2.03% 2.13% 2.23% 2.23% 2.33% 2.43% 2.43% 2.08%

In the second scenario, as you can see the rate at the last reset is the same as scenario #1. However, due to the fact that rates increased at a quicker pace in this scenario, the average rate of the advance increased to 2.08%. This scenario helps to clearly illustrate that timing and severity of the rate movements plays a vital role in what the overall rate of the advance will be.

Rate Scenario #3

Settlement Reset 1 Reset 2 Reset 3 Reset 4 Reset 5 Reset 6 Reset 7 Reset 8 Reset 9 Reset 10 Reset 11 Avg Rate
1.53% 1.58% 1.63% 1.73% 1.93% 2.03% 2.13% 2.13% 2.13% 2.33% 2.43% 2.43% 2.00%

Again, keeping with the same theme of the rate being 2.43% on the last rate reset date, we now look at rates initially increasing at a slower pace. As you would imagine, this results in the average rate of the advance being lower than corresponding bullet advance. In all three scenarios, 3M LIBOR has increased 90 basis points in three years, but due to the timing of the increases, the average rate of each advance is different.

Rate Scenario #4

Settlement Reset 1 Reset 2 Reset 3 Reset 4 Reset 5 Reset 6 Reset 7 Reset 8 Reset 9 Reset 10 Reset 11 Avg Rate
1.53% 1.78% 1.88% 2.13% 2.13% 2.38% 2.48% 2.73% 2.88% 3.03% 3.17% 3.17% 2.44%

Finally, it is important to look at a scenario in which LIBOR rates would increase significantly throughout the life of the trade. Of course, timing and severity still play an integral role in what the average rate will be, but in this scenario LIBOR has reached the strike rate, thus capping the advance rate at 3.17%. In our example, the advance rate remains at 3.17% for the last two reset dates, but in application there would be a chance for the advance rate to move lower if LIBOR were to fall back below the cap strike. These are just a handful of hypothetical scenarios to help consider the potential merits of using a Capped Floater in lieu of a bullet advance. Use your institution's projections for the trajectory of interest rates to help run similar simulations.

Capped Floaters to Fund & Hedge Commercial or Multi-Family Real Estate

Suppose you are looking to fund either multifamily or commercial real estate, float to fixed rate loans while also hedging as much risk as possible. Using a Capped Floater could be an excellent option to consider. Let's assume that the floating rate period for these loans is two years and the fixed rate period will be seven years. If you were going to fund and hedge a portion of these loans with a Capped Floater Blended Funding advance strategy, you could use the advance spread and rate cap to help price out the loan to your customer.

For example, let's assume you execute a 4-year Capped Floater advance indexed to 3M LIBOR to fund and hedge a portion of the first five years of the loans. If your advance has a spread of 0.29% to 3M LIBOR and the cap strike is 3.00%, the loans could be priced in a way that the floating leg has an acceptable spread to the Capped Floater rate and the fixed portion could be set at an acceptable spread to the Capped Floater cap strike. You have now locked in a spread for the floating rate portion while also setting a minimum spread for the fixed portion with the cap strike. Let's take a look at Table 4a and 4b to see how this would work in practice. We are looking to fund and hedge the first four years of the trade, funding the remaining years with deposits and/or short-term wholesale funding. We'll assume the loans have a spread of 2.50% to 3M LIBOR for the floating period and the fixed portion will have a rate of 5.0%. Additionally, we will only focus on the spread between the wholesale funding and the loans, ignoring the blended funding aspect of using deposits.

Table 4a. Floating Rate Leg

LIBOR Rate Capped Floater Rate CRE Loan Rate Spread
1.36% 1.65% 3.86% 2.20%
2.36% 2.65% 4.86% 2.20%
3.36% 3.29% 5.86% 2.57%
4.36% 3.29% 6.86% 3.57%
5.36% 3.29% 7.86% 4.57%

Table 4b. Fixed Rate Leg

LIBOR Rate Capped Floater Rate CRE Loan Rate Spread
1.36% 1.65% 5.00% 3.35%
2.36% 2.65% 5.00% 2.35%
3.36% 3.29% 5.00% 1.71%
4.36% 3.29% 5.00% 1.71%
5.36% 3.29% 5.00% 1.71%

As you can see, for the floating rate funding portion of the portfolio, you have locked in a minimum spread of 2.20%. As LIBOR increases, the spread can only improve due to the rate cap on the advance. Switching to the fixed rate leg, setting the fixed rate portion of the loan to a spread above the cap strike limits the downside risk if rates were to rise. Since the Capped Floater has a maximum rate of 3.29%, the worst case scenario, lowest spread possible is 1.71% during this fixed rate leg. When considering the entire trade, both floating and fixed, the absolute worst lifetime spread you could achieve would be about 1.96%, with a lot of upside. To achieve the minimum spread of 1.96%, 3M LIBOR would have to be below 3.00% for the entire first two years and above 3.00% the entire second two years. Although it is possible, the likelihood of that exact timing is low, meaning there is a great chance the wholesale funding portion of the deal will be over 200 basis points. When including deposits as part of a blended funding strategy, the weighted average spread would likely come in well over 2.00%.

In conclusion, whether you need funding for liquidity purposes or are looking to fund and hedge interest rate risk on a floating rate asset, it would be prudent to consider a Capped Floater.  The Capped Floater is a variable rate advance that provides a fixed limit to the maximum rate of the advance, combining the best of both worlds. Contact your Relationship Manager or the Strategies Team with any questions you may have regarding the Capped Floater.


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