Executive Summary

  • The current flattening yield curve gives finance executives an opportunity to enter into a constant maturity swap (CMS) transaction today that takes advantage of pricing only available in the flat yield curve environment.
  • When the curve steepens at some point in the future, returning to a more normal shape, the cash flows and/or overall mark-to-market value of the swap will be positive.
  • Constant maturity swaps tend to be less volatile than typical long-duration fixed-pay swaps on a mark-to-market basis. Additionally, they enable diversification of an organization’s portfolio of products.
  • The most significant risk with constant maturity swaps today is that the yield curve may not regain its historically positive slope in a timely manner. The nation’s economic history suggests that the yield curve will steepen, but how long might that take—a year or two? How steep might the curve be?
  • Financial executives should not use constant maturity swaps as “speculative plays,” but rather, as a risk-mitigation tool. Like with all financial products, thoughtful education is required to understand the risks and rewards of constant maturity swaps for a specific organization.

“It’s déjà vu all over again.” .... The question is, “Is it?”

Headlines in the financial press focus on the nation’s flattening yield curve, which historically has been a precursor to a recession. With uncertainty created by global market volatility, many finance executives in healthcare and other sectors are concerned that the nation’s prolonged economic expansion is about to slump. Their questions include:

  • If there is another recession, how extended and severe will it be?

  • What impact might a recession have on hospital and health system operations, investments, overall balance sheets, and competitive financial positions?

  • Might there be a way to mitigate negative effects and risks of a recession?

To address the last question, healthcare system executives are taking a close look at their investment and debt portfolios to minimize or mitigate certain risk exposure. Swaps, which are common tools of debt and treasury management, are of interest in this regard, as they can provide a way to hedge against future rate changes, obtain a cash-flow benefit, and shift risk exposure without issuing new debt.


One type of swap—a constant maturity swap—is applicable now due to its ability to help lower costs and assist balance sheets should the economy slow or enter into a recession. Constant maturity swaps were previously popular when the yield curve was similarly flat in 2005-2007. Market participants recognized that a flat yield curve was a temporary “aberration” and that a constant maturity swap could be employed resourcefully for capital structure enhancement.

Like many financing products, constant maturity swaps are not for all healthcare organizations. Finance executives must thoroughly understand their risks and rewards, and actively manage the swaps for the right debt balance given other enterprise risks.

Addressing new and tenured finance/treasury executives who may be interested in constant maturity swaps, this article describes how the product works, and specifically, the impact on constant maturity swaps of yield curve shape and actions taken by the Federal Reserve System. Additionally, it explains how today’s market environment differs from that existing in 2005-2007, the yield curve opportunity available in the current market, and the current risks and rewards of constant maturity swaps.1

Basics of Constant Maturity Swaps

A constant maturity swap is a floating-to-floating swap—also called a “basis” swap. The healthcare organization or “issuer” pays a floating rate based on a short-term index—e.g., 1-month or 3-month London Interbank Offered Rate (LIBOR)—in exchange for receiving from a “swap provider” a floating rate based on a longer-term index—e.g., 5-year or 10-year LIBOR swap rate (see “Constant Maturity” sidebar).

For example, Figure 1 illustrates a constant maturity swap (CMS) where the hospital issuer pays 67 percent of 1-month LIBOR in exchange for receiving from the swap provider 67 percent of a 10-year LIBOR CMS minus a fixed spread. Issuers also can elect to receive the CMS leg based on a flat (lower) ratio without the fixed spread component. The percentage of 1-month LIBOR the issuer pays typically reflects the rates of an underlying fixed-pay swap and original bonds the organization is trying to hedge with the original fixed-pay swap.



Impact of the Yield Curve and Federal Reserve Actions

The shape of the yield curve and the Federal Reserve’s efforts to cool down or heat up the economy by changing the Federal Funds rate2 both impact the economics of constant maturity swaps.

In the simplest terms, a yield curve is a line that plots the interest rates of securities that have equal credit quality but differing maturity dates. The X-axis is maturity date; the Y-axis is yield. As mentioned in a recent article, curve shape is important because it influences matters ranging from an organization’s capital structure composition to its transaction opportunities.3

An upward-sloping yield curve, which is typical in the securities/bond market and generally occurring in periods of economic expansion, reflects the fact that investors expect to be compensated more for holding bonds over a longer period. The yields on long-term bonds thus are greater than the yields on short-term bonds in an upward-sloping yield curve environment.

A flattening yield curve occurs when rates for short-term bonds move closer to the rates for longer-term bonds, such as 10-year or 30-year bonds. The flattening occurs due to declining yields on longer-maturity bonds and/or rising yields on shorter-term bonds. The shape of this curve typically reflects an economy that is transitioning from expansion to slower growth and even recession.4

An inverted yield curve reflects an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments. This shape has historically indicated a current or forthcoming recession.

Figure 2 compares the LIBOR swap yield curves across three different dates:

  • The blue line indicates the flat yield curve of the current (1/31/2019) environment, where the one-year rate is 2.69 percent and the 30-year rate a modestly higher 2.80 percent.
  • The gray line indicates the steep yield curve environment, post-credit crisis in February 2010, where the one-year (0.52 percent) to 30-year (4.59 percent) spread was the largest differential over the prior 15 years.
  • The red line indicates the flat yield curve in November 2006, when the smallest one-year (5.26 percent) to 30-year (5.14 percent) spread differential over the prior 15 years created a slightly inverted yield curve.

With its dual mandate of maximum employment and stable prices, the Federal Reserve System has the biggest impact on borrowers by affecting overall market liquidity as well as key benchmark interest rates.

The Fed has two tools to use in fulfilling its mandate.

Its primary tool is increasing or decreasing the Federal Funds rate, thereby affecting the supply of money in circulation. Lowering the Fed Funds rate generally increases the supply of money and encourages banks to take these new dollars and inject them into the economy in the form of new loans to consumers and companies. This “easy” or “accommodative” monetary policy creates liquidity and reduces the cost of credit in a manner that typically stimulates economic activity and drives growth. Fed Funds rate reductions also typically create an upward-sloping yield curve.

Raising the Federal Funds rate decreases the supply of money because the higher Fed Funds borrowing rate slows bank lending to consumers and companies, thereby reducing overall liquidity and cooling economic activity.  This action typically creates a flattening yield curve.

Quantitative easing (QE) or quantitative tightening (QT) is the Federal Reserve’s second tool. It works on the longer-end of the yield curve and involves the Fed’s purchase (QE) or sale (QT) of longer-dated bonds, either injecting or reducing liquidity in the market respectively.

After the Lehman Brother’s bankruptcy filing in September 2008, the Federal Reserve intervened in the markets in a massive way. It aggressively  purchased enormous quantities of bonds and lowered the Federal Funds rate, moving it from 5.25 percent in October 2007 to a historically low 0-0.25 percent by the end of 2008 (Figure 3). The economy responded to this support on the short end by starting a long growth/expansion period. The Federal Reserve kept the rate near zero until late 2016.

Meanwhile, continued long-term bond purchase by the Fed for more than a decade pushed longer-term borrowing rates, such as those for 30-year fixed-rate mortgages, down to their lowest levels in generations.5

Starting in 2016, to bring interest rates from an extremely accommodative stance to a neutral position, the Fed started raising the Fed Funds rate in small steps, and reducing (selling) its bond stockpile. By January 2019, the Fed Funds rate was 2.5 percent (upper bound target); the supply of bonds was shrinking at a rapid clip of $50 billion per month.  Then, at the end of January 2019, the Fed signaled that the case for raising rates had weakened somewhat due to economic volatility and diminished growth prospects, so it potentially could slow bond sales and leave the Fed Fund rate steady at 2.5 percent for the time being.7



Figure 4 illustrates how the yield curve has responded to recent developments, reflecting two contrasting actions:

  • The front, short-term part of the curve (1-month LIBOR, blue line) is moving higher, driven mainly by the Fed’s actions starting in 2016, as it raises the short-term borrowing rate to try to get back to more normal footing given the economy’s recovery and expansion.
  • In the back, long-end part of the curve (5Y CMS, red line, and 10Y CMS, gray line), a similar rate of increase in rates has not occurred. This likely reflects market sentiment about economic conditions; investors are concerned that Brexit, increasing tariffs, and other geopolitical risks are dampening the prospects for continued economic growth.

The result is that the front end of the yield curve is going up faster than the back end of the curve, thereby flattening the curve. The interest rate for one-month LIBOR (2.50 percent) is close to the 5-year and 10-year rate for constant maturity swaps (2.67 percent and 2.78 percent respectively).



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