Constant Maturity Swap (CMS)

A Constant Maturity Swap (CMS) is a type of Interest Rate Swap where two parties agree to exchange interest payments. What makes it special is that one of the payments, known as the “CMS leg,” is tied to the yield of a specific long-term financial instrument, like a 10-year government bond or a 10-year swap rate. This rate is reset periodically (e.g., every six months) based on the current yield for that specific maturity. The other payment, the “floating leg,” is typically based on a standard short-term Floating Interest Rate, such as SOFR. In essence, one party swaps a series of short-term interest payments for a series of payments based on a long-term interest rate. This allows institutions to take a view on, or protect themselves against, changes in the shape of the Yield Curve—the relationship between short-term and long-term interest rates.

Imagine a seesaw. On one end, you have the steady, predictable up-and-down of short-term interest rates. On the other, you have the slower, heavier movements of long-term rates. A CMS is a contract that lets you bet on which end of the seesaw will be higher over time.

Every swap has two sides, or “legs.” In a CMS, they are:

• The CMS Leg: This side pays an interest rate equal to the yield on an instrument with a “constant maturity.” For example, the 10-year swap rate. The key is that every time the payment is calculated, the contract looks at the current 10-year rate. It's not a 10-year bond that gets older; it's always the rate for a brand new 10-year instrument.
• The Floating Leg: This side typically pays a common short-term floating rate, like the 3-month SOFR, often plus or minus a small, fixed percentage called a spread.

These interest payments are calculated on a Notional Principal, which is a theoretical amount of money used just for the math. No actual principal is exchanged; only the difference between the two calculated interest payments changes hands.

Let's say a bank (Party A) enters into a $20 million CMS with an investment fund (Party B).

1. Party A agrees to pay Party B the 5-year swap rate, reset every six months.
2. Party B agrees to pay Party A the 3-month SOFR rate + 0.25%, reset every three months.

If, at the first payment date, the 5-year swap rate is 4% and SOFR is 3%, Party A owes a payment based on 4%, while Party B owes one based on 3.25% (3% + 0.25%). Party A will make a net payment to Party B for that period. If the yield curve later flattens and the 5-year rate falls to 3.10% while SOFR is 3%, Party B would end up making a net payment to Party A.

Unlike buying shares in a wonderful business, a CMS is a zero-sum game. For every winner, there is a loser. So why bother? The two main reasons are Hedging and Speculation.

Many financial institutions, like mortgage lenders or insurance companies, have a natural mismatch. They might earn revenue based on long-term rates (like 30-year mortgages) but have costs tied to short-term rates (like customer deposits). If short-term rates rise faster than long-term rates (a flattening yield curve), their profits get squeezed. A CMS can help them manage this Interest Rate Risk by swapping some of their long-term rate exposure for short-term rate exposure, or vice-versa, to better align their assets and liabilities.

A CMS is a powerful tool for betting on the future shape of the yield curve.

• If you believe the curve will steepen (long-term rates will rise more than short-term rates), you would want to receive the fixed CMS rate and pay the floating rate.
• If you believe the curve will flatten or invert (short-term rates will rise more than long-term rates), you would want to pay the fixed CMS rate and receive the floating rate.

For a Value Investor, the world of complex Derivatives like the Constant Maturity Swap is usually a “too-hard” pile, and for good reason. Our philosophy is built on clarity, simplicity, and a deep understanding of what we own. Here's the bottom line:

• Complexity is the Enemy: Warren Buffett has referred to derivatives as “financial weapons of mass destruction.” A CMS is a prime example of an instrument that is incredibly difficult to value, with outcomes dependent on the chaotic dance of interest rates. It's a world away from valuing a business with predictable cash flows.
• Stay in Your Circle of Competence: Is understanding the intricacies of yield curve speculation part of your Circle of Competence? For the vast majority of investors, the answer is a resounding no. Time is better spent analyzing businesses, not financial abstractions.
• Beware of Hidden Risks: Swaps introduce Counterparty Risk—the danger that the other party in the agreement will go bust and be unable to pay. When you own a stock, your primary risk is the business itself. With derivatives, you're adding a layer of risk that is often opaque and hard to assess.

While you will likely never need to use a CMS, understanding that they exist is useful when analyzing large banks or insurance companies. If you see a massive derivatives book in a company's annual report, treat it as a yellow flag. It's a sign of complexity and potential hidden risks that even the company's own management may not fully understand.