Constant maturity is a technique used to compare yields on bonds with different maturities. This method adjusts the yields of bonds to a common benchmark, making it easier to compare them. Constant maturity interpolation is widely used to calculate U.S. Treasury yield curves and accommodate rates on adjustable mortgages. It is also used in certain types of swaps contracts to standardize the cash flows owed or due on the swap agreement.
Basics
The Federal Reserve Board uses an adjustment called constant maturity to calculate an index based on the average yield of different Treasury securities maturing at different times. This adjustment ensures that yields are equivalent across various maturities. Constant maturity yields are a standard reference for pricing different types of debt or fixed-income securities. The most widely used constant maturity adjustment is the one-year constant maturity Treasury (CMT), which indicates the one-year yield equivalent of the most recently auctioned Treasury securities.
Understanding Constant Maturity Metrics
The constant maturity concept reflects the theoretical value of U.S. Treasuries, determined through daily interpolation of the Treasury yield curve. Calculated by the U.S. Treasury, it relies on recent auction values and closing bid-yields of actively traded Treasury securities. Lenders commonly employ constant maturity yields to gauge mortgage rates, with the one-year constant maturity Treasury index serving as a prominent reference for annually adjusted rates in adjustable-rate mortgages (ARMs).
As these yields originate from risk-free Treasuries, lenders factor in risk by applying a premium to borrowers, resulting in a higher interest rate. For instance, if the one-year constant maturity rate is 4%, a lender may charge a borrower 5%, with the 1% difference serving as the lender's risk compensation and gross profit margin.
Constant Maturity Swaps: Managing Interest Rate Risk
Constant Maturity Swaps (CMS) represent a variant of interest rate swaps, enabling the purchaser to stabilize the duration of received flows. In CMS, one leg's rate is fixed or reset regularly based on LIBOR or another floating reference index rate, while the floating leg fixes against a point on the swap curve to maintain constant cash flow duration.
Post-swap, a flattened or inverted yield curve favors the constant maturity rate payer over a floating rate payer, mainly when long-term rates decrease relative to short-term rates. Conversely, a fixed-rate payer benefits from an upward shift in the yield curve.
Consider an investor anticipating a steepening yield curve, where the six-month LIBOR rate falls compared to the three-year swap rate. To capitalize on this, the investor acquires a CMS, paying the six-month LIBOR rate and receiving the three-year swap rate.
Constant Maturity Credit Default Swaps (CMCDS): Hedging Default Risks
Constant Maturity Credit Default Swaps offer a hedge against default losses with a floating premium resetting periodically. The floating payment corresponds to the credit spread on a CDS of the same initial maturity at reset dates, distinguishing it from a conventional fixed premium CDS.
Interpolated Yield: One-Year Constant Maturity Treasury
The one-year constant maturity Treasury is derived from the interpolated one-year yields of the latest auctions of U.S. Treasury bills (4-, 13-, and 26-week durations), Treasury notes (2-, 3-, 5-, and 10-year durations), and the Treasury 30-year bond, along with off-the-run Treasuries in the 20-year maturity range.
Conclusion
Constant maturity serves as a vital technique for comparing bond yields with different maturities, offering a standardized benchmark for effective comparison. This method, widely employed by the Federal Reserve Board, facilitates the calculation of key indices, such as the one-year constant maturity Treasury (CMT), providing a consistent reference point for various debt instruments. Beyond bonds, constant maturity principles extend to interest rate swaps, enhancing risk management by stabilizing cash flows. As an integral component of financial markets, constant maturity's adaptability, from Treasury yield curves to credit default swaps, underscores its significance in ensuring financial instruments' coherent evaluation and risk mitigation.