Steepeners flatline

The US and euro yield curves have remained flat for much of the year, heaping misery on those investors that bought billions of dollars worth of CMS steepener products in 2005. Dealers are offering advice on restructuring, but there's only so much that can be done to ease investors' pain

Flat yield curves in the US and Europe have marred the performance of constant maturity swap (CMS) spread option products, leaving investors nursing negative mark-to-market positions with impaired coupons. Some investment banks have reached out to their clients by offering restructuring options and alternative structures. However, the extreme flatness of the yield curve in both the US and Europe has made structurers' task a difficult one, leaving some investors with no choice but to hold onto their beleaguered positions.

CMS spread option products were sold aggressively to institutional clients last year as a way to take a view that the current shape of the yield curve was too flat on a forward basis and would probably steepen (Risk October 2005, pages 20-22; February 2006, pages 18-20). The products were also widely distributed to European retail investors who were attracted by high initial coupons. However, instead of steepening as many economists and rate-watchers predicted, the euro and the US dollar curves have continued to flatten, leaving CMS spread option products with worsening mark-to-market losses.

Under-performing CMS structures have caused anxiety for investors since the yield curve began to flatten dramatically earlier this year. In February, the 10-year minus two-year euro CMS spread fell to 51.73 basis points. The spread is currently at 16.8bp, compared with more than 100bp at the start of 2005.

"Many investors believed in the steepening of the curve, and these products were sold promising money on steepening that didn't arrive," says Carlo Acerbi, head of financial engineering at Abaxbank, a boutique investment bank in Milan. "Investors are disappointed now in the dramatic losses in portfolios that are stuck in these positions."

With the curve so flat and expected to remain so for the medium term, investors' problems aren't going away. To help them out, investment bankers have, in some cases, stepped in to offer customers some advice on restructuring opportunities. "With any market phase like this, when there's a lot of uncertainty, our main goal is to make sure customers feel there's an opportunity to do something if they want to," says Kara Lemont, European head of interest rate and foreign exchange structuring at BNP Paribas in London.

The most popular CMS spread option products sold last year were so-called steepeners that pay a high coupon for the first year, after which the investor is paid a coupon based on the spread between two CMS rates - for instance, 10-year minus two-year - which is then geared three or four times. The steeper the yield curve, the greater the payout for investors.

These products have suffered on a mark-to-market basis, with some structures now trading as low as 50% of par. While investors would still receive the high initial coupon in the first year, they would subsequently receive a payout based on the CMS spread. With the yield curve flattening over the past year, investors would have received a significantly lower coupon than they had been expecting. And with the European yield curve looking likely to remain flat for some time, the outlook for these steepeners remains bleak.

"The products paying a multiple of the spread are suffering in terms of both coupon and mark-to-market," says Gonzague Bataille, head of financial engineering, structured interest rate derivatives, at Societe Generale Corporate and Investment Banking (SG CIB) in Paris. "The actual coupon is quite low and the expected coupon for the next two years is also quite low, which means the mark-to-market is not very good."

Classic steepeners aren't the only CMS products that have suffered - range accruals are also floundering. These products pay a high coupon so long as the 10-year minus two-year CMS spread remains within a pre-specified range or is above a certain barrier for every day of the coupon period. For instance, a product might pay a high fixed rate, multiplied by the number of days in a coupon period the 10-year minus two-year CMS spread is above zero, divided by the total number of days.

"We were playing the fact that the curve was unlikely to strongly invert over a long period of time," explains Bataille. "We designed products with binaries or range accruals with a high fixed-rate coupon or positive indexation to Euribor CMS with the condition that the slope was positive. So these kinds of steepeners are suffering in terms of mark-to-market, but less in terms of coupon."

When the US and euro yield curves flattened, investment banks active in CMS structured products quickly realised they might have some anxious customers on their hands. Most took action to help clients manage their positions. Unfortunately, in many cases, there wasn't much the banks could do.

"We have been quite proactive about contacting clients if they have positions that are underwater," says BNP Paribas' Lemont. "We have been offering clients alternatives, but the problem is that a lot of steepeners now on a forward basis are paying a forward spread that is close to a zero coupon, so they don't get a lot of value for those. What we've been advising clients to do, if they're comfortable, is to stay with them. They're not really saving themselves much now."

Some analysts believe the yield curve could stay flat for the next year or two. That means it is the worst time to unwind trades, as investors will be locking in prices at all-time lows. Accordingly, most banks are taking a similar view - hold on and hope for the best. Where possible, however, there has been some restructuring - for instance, tweaking barriers to increase the likelihood of coupon payments.

"We suggest our clients keep their positions, and we can mitigate the barrier for the next year or so and design solutions to lower it and be able to boost the coupon," says SG CIB's Bataille.

To give a bit more of a boost to the impaired notes, structurers are adding alternative risk - currency or credit, for example - to keep the coupon payments higher over the next two to three years while the yield curve remains flat. With range accruals, banks have been moving the lower barrier on the CMS spread below zero and adding in a foreign exchange component. These structures are called dual rangers, where the fixed coupon is multiplied by the number of days the CMS spread is above the lower barrier, as well as the number of days the euro/US dollar exchange rate is below a certain level.

"We've done some restructuring with non-bank accounts, insurers and private banking clients. We were expecting to see more, but it's not easy because investors need to extend the maturity or risk principal to restructure now. There are not many alternatives on a like-for-like basis," says BNP Paribas' Lemont.

The lack of alternative investment opportunities has posed problems for some investors wanting to trade out of their positions. Many are holding on to CMS products hoping the curve will steepen, allowing them to sell out at a reduced loss.

"These portfolios are stuck and people are reluctant to put this liquidity into new products," says Abaxbank's Acerbi. "The market is in a becalmed state right now. It is very difficult for people to sell anything, because their money is tied up in the huge amount of CMS steepeners or similar products sold last year. Investors are hoping for some steepening to bring some oxygen into the markets, allowing them to sell at higher levels."

Despite CMS steepeners' disappointing performance, investment banks report continued demand for these products, albeit greatly diminished from that experienced last year. However, steepeners are being marketed in a slightly different way these days. Taking into consideration that the curve - at least in Europe - is not expected to flatten much further, but may not steepen for another one to two years, CMS steepeners are being offered as a value proposition to investors.

"BNP Paribas bought a portfolio of notes from a bank earlier this year and there were a lot of steepeners in it that were trading down around 70% of par," says Lemont. "We're actively selling those because investors see them as a good opportunity with limited downside." Lemont declined to name the bank from which BNP Paribas bought the portfolio.

Most of what is being sold is being done so on a secondary market basis, rather than through the new issuance market. Investors such as banks and insurance companies are picking up distressed steepener positions, but the level of activity is limited.

"If one believes the curve is going to steepen, it's certainly a very compelling time to put on a steepener trade," says a London-based interest rate derivatives head. "The 10-30-year curve in Europe is less than 20 basis points currently, where it was 40-50bp in the past. It's an even more attractive time to enter into the trade now. Some investors are taking that view, but it's clearly an aggressive view."

No matter how compelling the argument for taking up distressed steepeners, it hasn't been an easy sell. The memory of how these products have performed is all too fresh in investors' minds.

"The problem is that most of the institutional investors were disappointed with the absence of liquidity they found when they asked for prices for their CMS positions," says Stefano Fassone, global head of sales, fixed income and derivatives at Banca IMI in Milan. "They are very sceptical to enter into the same kind of position, even if they are buying the bond at 80% of par, because they think that even if these trades should work, they could be difficult to unwind."

While the steepeners remain on some investors' blacklists, their less complex but still under-performing cousins, CMS-linked bonds, are experiencing a minor revival. CMS-linked bonds are usually issued as Tier I capital and offer a high fixed coupon for a certain period of time, subsequently paying a floating-rate coupon linked to a CMS rate. Like the steepeners, CMS-linked bonds were widely issued in 2004 and 2005 and were sold in huge amounts to institutional investors, as well as the high-net-worth and retail customer bases.

"What we've witnessed over the past few weeks is interest from institutional portfolios, such as pension funds and long-term buy-and-hold investors, which want to buy some old issues, particularly the CMS bonds, but not the steepener," says Fassone. "They're mostly looking at supranationals issued one or two years ago that were embedding only the CMS bet without any steepening features. There is value first of all because they are buying at market levels, which in most cases now reflect the real value of the bond, so there is no new issue premium."

Investment banks have not given up on CMS products entirely. There is optimism for US dollar products, as the Federal Reserve appears to be near the end of its cycle of rate hikes. A few products aiming to monetise views that short-term rates will not rise further in the US and that the forward curve will steepen have been rolled out. "We see much more potential for steepeners in US dollar quantoed into euros, because of the difference in timing in the economic cycle, as the Fed has probably peaked in terms of their short-term rates," says SG CIB's Bataille. "The entry levels are good now in US dollars and the potential for performance over a medium-term horizon is much more significant in dollars than in euros."

In Europe, meanwhile, banks have been offering alternative structures. For instance, BNP Paribas has been marketing euro-denominated volatility notes this year, which pay the difference between the highest 10-year euro CMS rate and the lowest 10-year CMS rate during each coupon period, multiplied by a certain gearing factor. Other variations pay a high fixed coupon, for instance 6%, so long as the difference between the highest and lowest 10-year CMS rate is above a pre-specified barrier.

"There are still some interesting opportunities on the euro slope," adds Bataille. "They're not the same products we were doing a year or two ago. They have to be more sophisticated with more flexibility if the curve will be flat or inverted in one or two years, so the customer will be protected against this scenario."

Floating-rate range accruals have also emerged, where investors are paid the 10-year euro CMS rate, times a gearing factor that is dependent on the number of days interest rates remain within a range.

"The idea is that investors are getting the same coupon structure as the range accrual coupon with a ratchet feature that risks all the future coupons as well, but we did the underlying coupon as floating rate," explains BNP Paribas' Lemont. The bank has issued a few series of these new notes this year, worth close to EUR600 million in notional volume.

Taking a position on curve flattening is another option for investors. Flattener trades have not been widely marketed, but are something Abaxbank has offered this year. "Flatteners can be used as a hedge for a portfolio of distressed CMS positions," says Acerbi. "By buying flattener certificates, investors can neutralise their positions. Treated with care, they can be very flexible instruments for hedging purposes, but they are intended to be used by aware investors because you have to be able to compute exactly your portfolio's sensitivity to steepening in order to buy the right hedging amount of certificate."

No-one is ready to shelve CMS steepeners permanently. While they have failed to perform, there is a time and a place for them, argue structurers. However, next time around, investors could shy away from such offerings after having such a bad experience and losing so much money.

And for the investors stuck with distressed CMS steepener positions, especially in euros, it looks to be long road ahead before they start to perform. The consensus view now is that while most of the flattening is behind the market, the European Central Bank (ECB) will continue to hike rates, which stood at 3.25% at the end of October, possibly stopping at 3.75%. Once the ECB stops raising rates, the market will start to price in some steepening - but that's not on the cards for another year, at the earliest, say analysts.