RBC’s $6 million redeemable steepeners on CMS seen as sign of renewed interest in rates play

By Emma Trincal

New York, April 18 – Royal Bank of Canada’s $6 million of redeemable leveraged steepener notes due April 13, 2028 linked to the 30-year Constant Maturity Swap rate and the two-year Constant Maturity Swap rate is one among a few new issues linked to interest rate swap spreads to hit the market recently, suggesting that the bet on a steeper yield curve is making a comeback despite concerns over the flattening of the curve.

RBC deal

The notes are callable annually after one year and offer a teaser rate of 6% for the first two years, according to a 424B2 filing with the Securities and Exchange Commission.

After that, the interest rate will be 8.5 times the spread of the 30-year CMS rate over the two-year CMS rate, subject to a minimum of zero and a maximum of 8% per year.

Interest will be payable quarterly.

The payout at maturity will be par.

RBC Capital Markets, LLC is the agent for the notes (Cusip: 78014RAE0), which priced last week.

“RBC did a decent size on this one,” said a bond trader, who sells steepeners to some of his clients.

Other firms, such as GS Finance Corp., Morgan Stanley Finance LLC and Citigroup Global Markets Holdings Inc. typically bring bigger size steepener offerings ranging between $10 million and $20 million, according to data compiled by Prospect News.

“My concern is that the spread right now is so tight, even with a big multiplier you’re not getting much. I’m not too excited about this one with 8.5 times. That’s just not enough,” he said.

Tight spread

The current spread between the 30-year CMS rate and the two-year CMS rate is 21 basis points. The floating rate if paid today would only be 1.78% after applying the 8.5 times multiplier.

“Right now steepeners priced at par are not very attractive,” he said.

The flattening of the yield curve between those two maturities has accelerated in the last six months, he said, with the spread dropping 70 bps since November.

“This has created opportunities for secondaries. Now you can find very cheap steepeners out there. When the spread falls by 70 bps with a 10 time multiple... that’s 7% worth of coupon that’s lost. People don’t want to hold on to those notes. They’re close to zeros.”

Renewed interest

The bid for new issues of steepeners, however, seems to have gained traction, according to data compiled by Prospect News.

On Monday, Citigroup Global Markets Holdings Inc. priced $2.25 million of callable fixed-to-floating notes due April 18, 2023 linked to the leveraged difference between the 30-year and two-year CMS rates, according to a filing with the SEC.

Interest will be 5% for the first year. After that, the rate will be equal to 18.5 times the spread of the 30-year CMS rate over the two-year CMS rate, subject to a maximum rate of 10%. Interest will be payable quarterly.

The payout at maturity will be par. The notes (Cusip: 17324CTV8) are callable quarterly in whole at par after one year.

Multiples, tenors

“When you see a high multiple like that, it really means that the market expects the curve will stay flat for a while. They’re giving you a nice incentive to buy it,” he said.

Five years ago, he added, when the 30 minus 2-year CMS spread was wider – over 3% at that time – issuers used to offer multipliers of four times with a 10% teaser rate.

“You didn’t need a lot of leverage back then. But as spreads tightened you began to see multiples of five times, seven times, 10 times...Now you see 18.5 times.”

If the high leverage seems to reflect the risk of inversion, some investors are considering the opposite view: the curve is so flat at the present time, the spread can only widen.

This trader agreed but said the curve may remain flat for a while.

“I’d rather look at a 20-year with 10 times rather than a five-year with 18.5 times,” he said.

“It’s going to give me more time to adjust to the yield curve. We’re moving into the next cycle but it doesn’t necessarily happen overnight.”

Outside the box

With new issues, agents are being creative to offset the meager spreads.

In order to improve the initial fixed rate or increase the multiple, they use a variety of features. An issuer’s call is one way to do it, as with the RBC deal. Other agents are using longer tenors or adding an equity component.

Morgan Stanley Finance LLC for instance announced for the end of the month a 15-year steepener structured as a range accrual based on the worst of S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index. The notes offer as a floating rate 15 times the spread of the 30-year ICE swap rate over the two-year ICE swap rate. A 10% fixed rate is guaranteed for the first two years. After that, it will be 15 times the spread of the 30-year ICE swap rate over the two-year ICE swap rate for each day that each index closes at or above its 60% reference level, up to a cap of 10% per year. The payout at maturity is par unless any of the indexes loses more than 50%, in which case the notes give exposure to the decline.

Big discounts

The bond trader said that right now, regardless of the bells and whistles offered by new deals, he still sees more value in the secondary market.

“The spreads have tightened so much there’s almost no coupon. That’s why secondaries now are selling for very cheap,” he said.

“I was looking at a 12 year trading at a price of 76. They’re like strip bonds. These are deep discounts.”

Most of the current value of those secondary deals, he explained, lies in their discounted price rather than the coupon.

“It’s like buying an old car but you get great, great value.”

This is also the view of a buysider who has found those secondaries very attractive and is showing them to his clients in quest of yield.

Deep value

“Secondary steepeners...If there’s anything that’s approaching a screaming deal, that’s it,” said Jerry Verseput, president of Veripax Financial Management.

He said he just bought a 10x leveraged steepener with 12 years left in it for $7,500 for an investment value of $10,000.

The discount gives him $2,500 of gains over 12 years, which is 2.5% a year as the notes were not sold at par.

In addition, the 21 bps leveraged spread gives him 2.8% in current yield.

“You can find ridiculously good deals like that,” he said.

The notes are tied to the same 30 minus two year CMS rates with a leverage factor of 10.

“I like that part of the curve. That’s where you have the less chance of an inversion,” he said.

Yield curve expectations

A flat yield curve, which may precede an inverted curve, one of the early signs of a recession, makes many investors nervous in the market. Not this adviser.

“We could have an inverted yield curve but historically it doesn’t happen very often and it doesn’t last very long” he said.

Verseput is now buying the notes for the discount. But he predicts that floaters will ultimately increase as the curve will be steepening.

“We’re close to the bottom of the cycle. The spread is going to widen. When the curve is flat, it doesn’t stay flat for long. Eventually it widens out. Then you own those cheap steepeners with increasing yield and that’s a great hedge against inflation.

“A lot of people are scared about those products. The Fed is raising rates on the short end and inflation is not visible yet keeping a lid on the long rate. That’s why the curve is flat. Instead of waiting, I’m buying now. It’s a phenomenal buy point.”

A tale of two markets

The bond trader said these trades make for a large portion of his business because values are enticing.

“I’ve even seen a 12-year at 60. Deep, deep discounts,” he said.

In comparison, dealers and distributors have so far been struggling to get significant bids on new deals.

“The new issues business has dropped significantly,” he said.

“Spread are so tight, people are not buying them at par. They’re getting rid of them because there’s very little coupon left in it,” he said.

But markets change rapidly and new issues may regain some appeal as investors could pay attention to the higher teaser rates or multiples.

“Look, there are different products for everyone. I personally like old cars. Some people prefer new cars.

“There are different ways to make the same bet, not just one. And no way is better than the other.”

© 2015 Prospect News.
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