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What is a CMS / CMT?(bond where coupon is not fixed and regularly reset based on swap/interest rates)

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  • October 2019
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  • What is a CMS / CMT?(bond where coupon is not fixed and regularly reset based on swap/interest rates)

Context:These bonds tend to be correlated to interest rates and as rates went lower, the price of these went lower too. The bonds that we own have been issued under Basel II and Solvency 1 and do not comply with new regulatory framework. We call them grandfathered. There is a lot of optionality owning such bonds in terms of future capital gains as banks/insurance companies will be looking to buy back such bonds at significant premium to current prices over the coming years.

Impact for the fund:Positive, as the market started pricing the potential regulatory call for loss of eligibility on such legacy bonds

CMS: Constant Maturity Swap

CMT: Constant Maturity Treasury

Discounted Perpetual Floating Rate Notes (FRNs) are legacy capital securities issued by banks and insurers under previous regulatory regimes (pre-Basel III for banks and pre-Solvency II for insurance). There are two broad categories of Discount Perpetual FRNs: Discount Perpetuals (DISCOs) and Constant Maturity Swap (CMS) or Constant Maturity Treasury (CMT) instruments. Given there is currently close to USD 15 billion outstanding securities in issuance between DISCOs and CMS/CMTs, this asset class remains a sizeable portion of the legacy subordinated debt market.

Both DISCOs and CMS / CMT instruments share common features, both being:

  • – Perpetual subordinated debt instruments issued under previous regulatory regimes
  • – Floating coupons with low margins (where the spread is paid above the reference rate) – typically below 50bps
  • – Periodically callable – this could be annually or more frequently

Given low floating margins, both instruments trade at deeply discounted prices to reflect these relatively low coupons. However, DISCOs are mostly US dollar-denominated instruments that were issued by banks in the mid-1980s and are indexed to Libor, while CMS / CMTs are mainly euro-denominated instruments issued by both banks and insurers in the early to mid-2000s (with some US dollar issuance) that are indexed to 10- year swap rates or government bond yields.

 

For more insights please refer to our article on Discos: “An opportunity in subordinated financial bonds?”

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