Going up? Elevating loan yields with swaps
Financial Institutions | Kennett Square, PA
Rather than simply accepting their fate and holding onto low-yielding floating-rate assets, financial institutions can use swaps to improve their net interest margin.
What a difference a year makes. Spring 2020 was like nothing we had ever seen: scheduled gatherings were cancelled and activity came to a screeching halt. Yet today, after a year highlighted by social distancing, lockdowns and restrictions, there is a sense of anticipation that feels like a wave of pent-up demand ready to break-out, much like the buds on a flowering tree. We saw the Prime rate plunge to 3.25% last year from its recent peak of 5% as the Federal Reserve pushed its target back to zero to help keep the economy afloat. Banks and credit unions that built up significant portfolios of variable-rate loans experienced the pain of this unexpected rate shock in the form of margin compression.
But as flowers bloom this spring, there is very little hope that short-term rates will follow suit. The Federal Open Market Committee signaled at its mid-March meeting that it expects to maintain a near-zero Fed Funds target all the way through 2023 with a goal of seeing inflation rise to more normal levels. For lenders holding floating-rate assets, waiting until the 2024 presidential primary season to experience any benefit from higher yields might seem unbearable. And with the sting of last year’s free fall still fresh, the prospect of slow and steady quarter-point bumps thereafter is not appealing.
Interestingly, there is a different story playing out when we examine the yields on longer-dated bonds. Because inflation erodes the future value of fixed-income coupon payments, bond market investors have grown nervous about the Fed’s increased desire and tolerance for rising prices. Consequently, while short-term rates have remained anchored, 10-year bond yields have surged by a full percentage point in less than six months, creating a sharply steeper yield curve. This is excellent news for asset-sensitive institutions that have interest rate hedging capabilities installed in their risk management toolkits. Rather than simply accepting their fate and holding onto low-yielding floating-rate assets in hopes the Fed will move earlier than expected, banks and credit unions with access to swaps can execute a strategy that creates an immediate positive impact on net interest margin.
To illustrate, consider an asset-sensitive institution with a portfolio of Prime-based loans. Using an interest rate swap, the lender can elect to pay away the Prime-based interest payments currently at a 3.25% yield and receive back fixed interest payments based on the desired term of the swap. As of March 23, 2021, those fixed rates would be 3.90% for five years, 4.25% for seven years, and 4.50% for ten years. So, with no waiting and no “ramp”, the loans in question would instantly increase in yield by 0.65%, 1% or, 1.25% for five, seven, and ten years respectively once the swap economics are considered. The trade-off for receiving this immediate yield boost is that the earning rate remains locked for the term of the swap. In other words, when Prime is below the swap rate (as it is on day one) the lender accrues interest at the higher fixed rate, but when Prime exceeds the swap rate, the lender sacrifices what is then the higher floating-rate yield.
This strategy uses a straightforward “vanilla” interest rate swap with a widely used hedge accounting designation. For banks that avoided balance sheet hedging because of complexity concerns, an independent advisor can help with the set-up process that will open the door to access this simple but powerful tool. And credit unions are eagerly awaiting the proposed rule changes from the NCUA that will simplify the regulatory application process to gain access to derivatives. The new rule is expected to receive final approval in the second quarter.
In the days following March 2020, we often heard that “the only thing certain in uncertain times is uncertainty.” With swaps in the toolkit, financial institutions have the power to convert uncertain interest flows to certain, taking control of the margin and managing exposure to changing interest rates in a more nimble and thoughtful manner.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0092
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