Constant maturity credit default swaps (or CMCDS) are credit default swaps in which the protection payments, rather than being for a fixed amount every quarter for the life of the trade, float up and down in line with prevailing credit spreads.
For example, in a five year CMCDS referencing Ford, the payments would be calculated each quarter as a proportion of the then current five-year credit default swap spread on Ford (called the reference rate). This percentage is known as the participation rate. The lower the participation rate, the higher the market’s views of forward spreads.
Source: B&B Structured Finance Ltd |
A forward is a contract which comes into force some time in the future, so a two year-into-five year forward credit default swap is a five-year contract starting two years from now. Forward spreads can be implied from the rates for credit default swaps of different maturities today. One simple way to think about it is that the difference between a 10-year credit default swap and a three-year credit default swap must be the same as the risk of default over seven years starting in three years’ time.
The steeper the credit curve (the graph of credit spreads plotted at different maturities), the steeper the forward curve, and the lower the participation rates offered on CMCDS. Since the CMCDS was first introduced around late 2003, participation rates have typically been low, implying steep credit curves. This has reduced protection sellers’ appetite for the product, since they are often unwilling to take on default risk for such low returns.
Also, when CMCDS were first introduced, many market participants thought that a CMCDS would reduce mark-to-market volatility in the same way that a floating rate bond has less mark-to-market volatility than a fixed rate bond. However, while the reference rate floats with prevailing credit spreads (similar to Libor), the participation rate is fixed and therefore the market value of the product changes as the shape of the credit curve changes.
As a result, volumes have been lower than many of the product’s promoters had hoped. Most activity has centred on single names, with a few synthetic CDOs also structured using floating spread coupons.