Basis Points: The Slope of the Yield Curve and How it Affects Refunding Escrows

While the term “normal yield curve” refers to a positively sloping yield curve, the marketplace has become accustomed to an inverted yield curve for quite some time.

The treasury curve, from the 6-month to 30-year point, has been inverted since September 2022. We’ve seen this create a benefit for issuers and borrowers who can earn positive arbitrage on their project funds and refunding escrows as we’ve referenced in previous articles.

The front end of the yield curve remains the most inverted. In May 2023 the delta between the 1-year and 3-year rates averaged around 106 basis points. More recently, however, we’ve begun to see this delta narrow and the yield curve has started to slowly flatten. In January 2024, the difference between these rates averaged at about 69 basis points. It’s likely that we won’t see the slope of this point of the curve become positive until the Fed cuts short term rates, and we have heard from the last FOMC meeting that they will remain cautious to do so.

The market certainly has mixed views of when the Fed will lower rates, but even the highest forecast published to Bloomberg’s economic forecast of the Fed funds rate suggests a cut sometime in 2024. While a positively sloping yield curve environment may not be imminent, it seems it could eventually be forthcoming.

Since it’s been a while since we’ve seen a positively sloping yield curve, we thought it would be a good time to recall how this shift can affect refunding escrows. When the front end of the yield curve is positively sloped, refunding escrows tend to earn more interest with open market securities (“OMS”) compared to State and Local Government Securities (“SLGS”). There are three main reasons that this occurs:

1. SLGS by Design

SLGS rates are designed to be 1 bps less than the treasury rate on any given day.

2. Tenor Rate Determination

SLGS rates are calculated as the rate between the day of settlement (which is typically 2-4 weeks following the day of pricing) and maturity. Conversely, OMS rates are locked in on the day of pricing using securities that earn interest from the day of pricing to the maturity date. As a result, SLGS portfolios utilize slightly shorter maturing securities and OMS portfolios utilize longer maturing securities. In an inverted yield curve environment like we see today, this is a benefit to SLGS. In a “normal” or positively sloping yield curve environment this distinction benefits OMS.

3. Negative Carry

When bidding OMS, the winning dealer purchases the securities on the day of bid/pricing (again, typically 2-4 weeks prior to settlement), and must hold those securities until the settlement date when bond proceeds become available, and the issuer purchases the portfolio from the dealer. The dealer must fund their purchase at a rate for the period between pricing and settlement (typically 2-4 weeks), and when the yield curve is inverted this rate is often higher than the rate on the portfolio. The result is that the dealer must charge a negative carrying cost. In a positive sloping yield curve environment, the funding rate is often less than the rate on the portfolio, and the dealer can even offer a premium for this rate differential.

While these factors haven’t come into play yet, OMS continue to benefit conduit borrowers and issuers in other ways. For bond funds and taxable escrows that are not eligible for SLGS, OMS are a reliable alternative, and can often produce positive arbitrage earnings in the current market.

Blue Rose offers reinvestment advisory services for OMS portfolios, as well as repurchase agreements and guaranteed investment contracts. For a more tailored reinvestment indication to your specific fund(s) and a discussion of the risks and benefits to each type of reinvestment structure, please reach out to Georgina Walleshauser at [email protected].

Georgina Walleshauser, Vice President | 952-746-6036

Georgina Walleshauser joined Blue Rose in 2017 as a Junior Quantitative Analyst. She has vast expertise in providing modeling, analytics, market data, and research in support of the delivery of capital planning, debt and derivatives advisory, and reinvestment services to our clients. As Vice President, she manages a number of the firm’s clients and ensures that transactions run smoothly through closing. She specializes in analyzing and assessing reinvestment strategies for clients, leading many of Blue Rose’s reinvestment transactions.

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