With constant maturity swap (CMS) spreads at historical lows, some investors believe the flattening yield curve cycle of the past three years has come to an end. As a result, a new wave of highly leveraged CMS spread steepeners is proving very popular. But how risky are they? Amanda Lee reports
Enthusiasm for constant maturity swap (CMS) steepeners has waned following mark-to-market losses in the past 18 months, when the US dollar interest rate yield curve flattened, at times to the point of inversion. Still, some dealers estimate that $2 billion to $3 billion of highly leveraged structures linked to CMS spreads were sold in Asia in the past nine months, a definite increase on 2005 volumes, say dealers, although none would give an estimate for that year. Big buyers were retail distributors and corporates in Taiwan and private banks in Singapore and Hong Kong. Most steepeners are denominated in US dollars, although some are quantoed into local currencies, such as New Taiwan dollars.
Although the new wave of CMS steepeners is not as popular with end-users as that seen three years ago when CMS spreads were higher, most investors believe US dollar yields will steepen inexorably at some point. CMS spreads are at historical lows - for example, the 30-year minus 10-year US dollar CMS spread was around 21 basis points as of April 25 - which enables issuers to apply high leverage factors to generate yield from a future steepening. For example, some of the new CMS spread leveraged notes feature a leverage factor of 50 times or more compared with leverage of around 10 times in 2005.
Indeed, some coupons now depend on the ratio of two CMS rates instead of linking the payout to the difference between two CMS rates, as witnessed in earlier deals.
Yet some issuers and distributors are unwilling to sell such highly leveraged structures to individual investors. Credit Suisse Private Bank, for example, only sells steepeners on a reverse-inquiry basis - where clients request such transactions. "Currently, our house research view on interest rates does not recommend such investments to clients," says Mark Wang, head of global product sales, southeast Asia private banking division at Credit Suisse in Singapore.
Demand for steepeners has grown sharply among retail distributors in Taiwan and Singapore, says Lana Lam, a Hong Kong-based director of interest rates derivatives trading at Societe Generale Corporate & Investment Banking (SG).
"We have seen a lot of banks trading steepeners since the end of last year," she says. "CMS spreads are at historical lows. For example, although it has widened recently, the 30-year minus 10-year spread was around 21 basis points on April 25, compared to 60bp at the end of 2005. The leverage factor then was between 10 and 15, but we can now apply a leverage factor of up to 50 or more with the same kind of transaction because the spread is so low. The most popular steepener we have sold is callable and based on two CMS rates - 30-year minus 10-year, with a tenor of between five and 15 years. Depending on the maturities, it can be geared up to 50 times."
The most common investment term for a CMS steepener - or CMS spread-leveraged note - is around 10 years, with a fixed coupon payable in the first year and subsequent coupons based on the spread between two CMS rates multiplied by a certain leverage factor.
"We have done 30-year minus 10-year spread transactions and 30-year minus two-year spread transactions, but typically with a leverage factor of no higher than 10," says Aniruddh Gupta, head of the client solutions group, fixed income at UBS in Hong Kong. "The risk profile of highly leveraged structures does not suit either us or our clients at all times. If we were to put the spread at 10-times leverage now, you would get a fairly high coupon of around 10% in the first year. With this kind of structure, we tend to put no more than 10-times leverage at the back end, and we probably won't be doing 50-times leverage."
In fact, as the US dollar yield curve continues to remain flat, steepeners have now become so highly geared that a new permutation of the classic steepener has emerged. Coupons are linked to the ratio of two CMS rates rather than the difference of two CMS rates. "We have structured some steepeners based on dividing the 10-year rates by two-year rates and then subtracting 100% from the ratio," says SG's Lam. "This way, the leverage effect is even more significant when the 10-year minus two-year spread changes. The structure plays on two factors: that spreads will widen further and that the two-year CMS rates will not increase to a high level."
Structurers are divided over the merits of using ratios or applying a high leverage factor to CMS spread-linked products. Gupta says UBS has not structured any steepeners that depend on ratios, adding that these are not suitable for its clients.
Steepeners based on ratios are a step forward in terms of leverage, says Alessio Caldarera, interest rate strategist at BNP Paribas in London. "The fact you are using a ratio as opposed to spreads or actual rates is purely a matter of getting a more highly geared product," he says. "It's a way for investors to have leverage like hedge funds without having to go through credit requirements."
Steepener structurers say they are receiving a growing number of requests for transactions with extremely high leverage. In some cases, investors have asked for the spread to be geared by a factor of more than 100 times. "A lot of investors want these highly leveraged notes, but many banks don't want to quote on them," says Charles Wong, executive director of interest rate structured products in Asia at JP Morgan in Hong Kong.
JP Morgan has traded many of these highly leveraged structures, but Wong says steepeners are now so tightly priced that the fees charged on them do not necessarily compensate the dealers for the additional risk they have to undertake. "The amount of hedges you have to do for 100 times the curve differentials is 100 times the notional," he says. "From a risk management perspective, you have a big curve position."
Others agree it can be difficult for investment banks to hedge highly leveraged steepeners, such as those with payouts linked to ratios. "This type of structure would have been expensive when CMS steepeners were popular three years ago," says Frederik Stoop, head of structured products and origination at Fortis Investments in Brussels. "That's because the difference between 10-year rates and two-year rates at that time was at least 0.5% or so, making the structures more expensive. With negative spreads now, the structures are cheaper, but hedging them can prove difficult. And I am not sure whether investors can understand how the ratios work."
Yield curve familiarity
So how familiar are retail investors with the mechanism of the yield curve? "CMS steepeners are considered the next generation of interest rate-linked notes after Libor-linked callable range-accrual notes (Crans), which became commoditised in late 2002," says Wang at Credit Suisse. "Compared to plain-vanilla Crans, CMS steepeners have an added degree of complexity. Clients need to have a view on both the absolute level of interest rates, both spot and forward, as well as the shape of the CMS spot and forward curves. The latter concept is relatively new to most investors, and steepening or flattening in the CMS curve can result from several economic and market factors."
Some investors are now receiving lower coupons as a result of piling into CMS steepeners in 2003. "Given the very steep CMS spot curve in 2003, the forward market at that point in time was expecting significant flattening of the yield curve, the implication of which is extremely low coupons payable going forward," Wang says. "This point was made clear to clients when CMS steepeners were introduced at that time."
But steepeners form a relatively small proportion of the CMS spread-linked product market in Asia, say some structurers. CMS spread range-accrual notes have been consistently in demand even when the issuance of steepeners was down. These range-accrual products allow investors to profit when a specified part of the CMS curve - for example that between the two-year and 10-year rates - lies within a specific range. And most retail investors in Asia are comfortable with range-accrual structures because they have been applied to other retail structured products, such as equity-linked structured notes.
SG's Lam says: "Even when the market for interest rate-linked investments was quiet last year, for example, there were still a lot of CMS spread range-accrual notes around.
"Many CMS spread range-accrual notes distributed in the middle of last year have now been called, because a maximum coupon was paid out as interest rates were higher then and spreads were tighter," she adds. For example, for a typical 10-year callable range-accrual note based on 30-year minus 10-year rates, the maximum coupon paid out was more than 10% a year.
These notes were structured so that investors do not have to take an outright view of the steepness of the yield curve, says JP Morgan's Wong. "If you look at historical data, the curve has never stayed inverted for long," he says. "And for most of the range-accrual structure, the strike is set at or well below zero. So it doesn't matter if the yield curve is going to flatten a little, so long as it doesn't become too inverted for a very long time."
Meanwhile, issuers such as JP Morgan, SG and UBS expect more steepeners to be issued in the next few months, and to trade more of them, both for investment and hedging purposes.
"We see the possibility of one or two more quarter-point rate hikes by the US Federal Reserve late in 2007 and 2008 as a consequence of rising wages in the US," says Arjuna Mahendran, Credit Suisse's Singapore-based chief economist and strategist for Asia-Pacific. "Once this is anticipated by the financial markets, we expect a steepening of the yield curve to occur."
HOW DO CMS STEEPENERS WORK?
A constant maturity swap (CMS) is similar to an interest rate swap - an over-the-counter derivative that allows counterparties to swap cashflows determined by floating and fixed interest rates as specified in the contracts. However, with a CMS, the floating-rate portion is reset periodically according to a specified market rate, such as the two-year or the 10-year swap rate.
A CMS steepener, meanwhile, pays coupons based on the difference between two different swap rates - the spread. The coupons of such a structure depend on the slope of the yield curve. So the steeper the yield curve, the greater the coupon.
Since the start of 2006, both dollar and euro yield curves have flattened dramatically and have thus led to a fast-shrinking CMS spread. This has caused the classic steepener to underperform, and investors that had positions in CMS spread instruments took big mark-to-market losses due to a significantly lower coupon.
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