What Is a Constant Maturity Swap (CMS)?
A constant maturity swap (CMS) is a variation of the regular interest rate swap in which the floating portion of the swap is reset periodically against the rate of a fixed maturity instrument, such as a Treasury note, with a longer maturity than the length of the reset period. In a regular or vanilla swap, the floating portion is usually set against LIBOR, which is a short-term rate.
Put another way, the floating portion leg of a regular interest rate swap typically resets against a published index. The floating leg of a constant maturity swap fixes against a point on the swap curve on a periodic basis. In this way, the duration of received cash flows is held constant.
- Constant maturity swaps are interest rate swaps that smooth volatility associated with interest rate swaps by pegging the floating leg of a swap to a point on the swap curve on a periodic basis.
- Under a CMS, the rate on one leg of the constant maturity swap is either fixed or reset periodically at or relative to LIBOR or another floating reference index rate.
- The floating leg of a constant maturity swap fixes against a point on the swap curve on a periodic basis so that the duration of the received cash flows is held constant.
Basics of Constant Maturity Swap
Constant maturity swaps are exposed to changes in long-term interest rate movements, which can be used for hedging or as a bet on the direction of rates. Although published swap rates are often used as constant maturity rates, the most popular constant maturity rates are yields on two-year to five-year sovereign debt. In the United States, swaps based on sovereign rates are often called constant maturity Treasury (CMT) swaps.
In general, a flattening or an inversion of the yield curve after the swap is in place will improve the constant maturity rate payer's position relative to a floating rate payer. In this scenario, long-term rates decline relative to short-term rates. While the relative positions of a constant maturity rate payer and a fixed rate payer are more complex, generally the fixed rate payer in any swap will benefit primarily from an upward shift of the yield curve.
CMS in Practice
For example, an investor believes that the general yield curve is about to steepen while the six-month LIBOR rate will fall relative to the three-year swap rate. To take advantage of this change in the curve, the investor buys a constant maturity swap paying the six-month LIBOR rate and receiving the three-year swap rate.
The spread between two CMS rates (e.g., the 20-year CMS rate minus the 2-year CMS rate) contains information on the slope of the yield curve. For that reason, certain CMS spread instruments are sometimes called steepeners. Derivatives based on a CMS spread are therefore traded by parties who wish to take a view on future relative changes in different parts of the yield curve.
Due to recent scandals and questions around its validity as a benchmark rate, LIBOR is being phased out. According to the Federal Reserve and regulators in the U.K., LIBOR will be phased out by June 30, 2023, and will be replaced by the Secured Overnight Financing Rate (SOFR). As part of this phase-out, LIBOR one-week and two-month USD LIBOR rates will no longer be published after December 31, 2021.
Who Uses Constant Maturity Swaps and Why?
The constant maturity swap is employed by two types of users:
- Investors or institutions attempting to hedge or exploit the yield curve while seeking the flexibility that the swap will provide.
- Investors or institutions seeking to maintain a constant liability duration or constant asset.
The main advantages and disadvantages of a constant maturity swap are:
It maintains a constant duration
The user can determine “constant maturity” as any point on the yield curve
It can be booked the same way as an interest rate swap
It requires documentation from the International Swaps and Derivatives Association (ISDA)
It has the potential for unlimited losses