Break-Even Analysis of the Yield Curve: A Useful Guide for Positioning Your Balance Sheet

posted on Friday, July 1, 2016 in Strategies

John P. Biestman, CFA, Vice President
Federal Home Loan Bank of Des Moines

A “yield curve optimal point analysis” can measure changes in the slope of the yield curve and the “roll-down” benefit of various advance maturities.  It's often useful to evaluate the market's forward view of interest rates (much like a “point spread“ could project uncertain outcomes) and assess the optimal point on the yield curve to invest or fund your balance sheet.

Thus far in 2016, the yield curve has flattened significantly.  From 12/31/15 to 6/30/16, the spread between one-to-ten year advances has diminished from 196 basis points to 134 basis points.  On one hand, there could be possible impediments to further Fed rate hikes that might include: inconsistent employment situation reports, restrained inflation figures, and moribund global growth.  Still, the Fed could increase its proclivity toward a rate increase if we were to see increased evidence of an improved labor market or strengthening of price pressures.

Looking at the Yield Curve

It is always useful to look closely at the yield curve for clues about both historical and relative value.  Consider the data provided in Figure 1 (representing the yield curve based on FHLB Des Moines term advances as of June 30, 2016) and Figure 2 (representing the yield curve based on FHLB Des Moines term advances as of December 31, 2015). Derivation of the Break-Even Rate Rise metric follows:

  • Yield Pickup is calculated by subtracting the initial (one year) advance rate from advance rate of the specified maturity (advance rate year 2 – advance rate year 1, etc.)
  • Curve Roll-Down is calculated by subtracting the previous year Yield Pickup from the specified year Yield Pickup (yield pickup year 2 – yield pickup year 1, etc.)
  • Break-Even Rate Rise is calculated by adding: ((Curve Roll-Down) + (Yield Pickup/Maturity in Years – 1 Year) + (.01 + and additional .01 for each year of maturity))

Figure 1. Yield Curve Break-Even Rate Rise as of June 30, 2016

Advance Maturity Advance Rate Yield Pickup Curve Roll-Down Break-Even Rate Rise
1 Year 0.87
2 Year 1.02 0.15 0.15 0.31
3 Year 1.15 0.28 0.13 0.29
4 Year 1.38 0.51 0.23 0.43
5 Year 1.51 0.64 0.13 0.33
6 Year 1.68 0.81 0.17 0.38
7 Year 1.8 0.93 0.12 0.34
8 Year 1.98 1.11 0.18 0.41
9 Year 2.11 1.24 0.13 0.37
10 Year 2.21 1.34 0.10 0.34

Figure 2. Yield Curve Break-Even Rate Rise as of December 31, 2015

Advance Maturity Advance Rate Yield Pickup Curve Roll-Down Break-Even Rate Rise
1 Year 1.08
2 Year 1.41 0.33 0.33 0.67
3 Year 1.67 0.59 0.26 0.58
4 Year 1.97 0.89 0.30 0.63
5 Year 2.16 1.08 0.19 0.50
6 Year 2.38 1.30 0.22 0.53
7 Year 2.54 1.46 0.16 0.46
8 Year 2.79 1.71 0.25 0.56
9 Year 2.91 1.83 0.12 0.43
10 Year 3.04 1.96 0.13 0.44

Evaluate Your Options

From an investor's perspective, since the start of the year, there has been a diminished level of “roll-down” benefit, particularly associated with the two-to five-year sector of the yield curve. Phrased another way: A member investor might have two alternatives covering a one-year time horizon:

  • Purchase a one-year, fixed-income security (assumed to be pegged to the FHLBank advance yield curve) at 87 basis points, in this example.
  • Purchase a two-year security at 102 basis points, in this example, and sell it after one year.

At what point would you be better off purchasing the two-year security and selling it at the end of the first year, versus purchasing the one-year security? That is, should rates rise, even though some principal loss could be sustained on the longer-duration security, would the extra yield earned, relative to the one-year portion of the yield curve, more than offset the loss?

As of June 30, 2016, there were only 31 basis points of protection (versus 67 basis points of protection as of December 31, 2015) from rising rates for a member investor who opts to purchase a two-year security and sell it by the end of the first year. An investor would have made the right decision to invest in that two-year security, unless rates were to increase by more than 31 basis points during that one-year period.

We can generally observe “break-even” points on the yield curve to gauge the market's view of the most optimal place to invest, or, inversely, to fund a balance sheet. In the example presented, one might conclude the following about today's yield curve:

  • In historical terms, there is a limited amount of “insurance” available to protect investors from a principal loss in the event of a rate increase throughout the yield curve. Still, today's yield curve suggests that in relative terms, there may be merits to the use of funding in two, three or five-year maturities, versus, as an example, four-year maturities. As an example, the current environment may be conducive for executing term funding with “symmetrical prepayment” features. This structure, in the form of advances, would allow a member institution to prepay and monetize the value of a liability during a time of rising rates.
  • The currently flat yield curve underscores the importance for banks to challenge the assumptions in their ALM and liquidity models. Should rates increase, depositors may seek alternative sources of yield and require that banks pay up to replace any lost deposits. Loan durations could shift as well, as should demand accelerate for fixed-rate product. Those low-yield deposits that you counted on to be longer in duration may no longer be available to fund a surge in new fixed-rate loans. Now may be the time to consider complementing your deposit structure with longer, more duration-certain liabilities. You may also consider restructuring your deposit and product offerings. Is it time to revisit the withdrawal penalty period provisions for your time deposits? Should you reconsider the mix of your variable-rate loans relative to your fixed-rate loans in order to increase asset sensitivity?

Make it a habit to use a “break-even” analysis of the yield curve as an occasional review of the “point spread.” It can often be a good barometer of what an efficient market is telling you about how you might position your balance sheet.


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