01 Oct 2005, Risk magazine
UK 50-year linker breaks new ground
The UK has priced the first 50-year inflation-linked bond. The 1.25% gilt, due 2055, is the longest-dated sovereign index-linked bond in the world.
"We have successfully opened a new sector of the index-linked gilt market, matching the extension of the conventional gilt curve earlier this year," says Robert Stheeman, chief executive of the UK Debt Management Office (DMO). "The syndicate of banks that have delivered this result have assembled a strong order book from a broad range of investors, thereby setting the foundation for an active and efficient market for the new gilt."
The fact that the index-linked bond was issued via a syndicated offering was another first for the UK gilt market. The joint lead bookrunners were Barclays Capital, Morgan Stanley, Royal Bank of Scotland (RBS) and UBS. RBS also won the coveted role of duration manager on the deal.
The DMO opted for the syndication route instead of its usual auction process due to the 50-year gilt's innovative characteristics – in particular, the fact that the issue represented the opening up of a new sector of the sterling market, where few points of comparison exist for the purpose of pricing. The syndication process was seen as the best way to ensure a fair and transparent price formation process.
"The deal is an all-round winner. The DMO achieved what it set out to achieve – from the price discovery process through to the smooth execution of the trade," says Chris Thomas, head of sterling inflation at RBS in London.
The deal was placed primarily in the UK (90%) and the rest went to buyers in continental Europe. Of the UK buyers, many were pension funds, fund managers, insurance companies and banks.
Dealers back CME inflation futures
Barclays Capital, Ixis Corporate and Investment Bank, Lehman Brothers, Nomura International and the Royal Bank of Scotland have all agreed to become market-makers for the Chicago Mercantile Exchange's (CME) new eurozone inflation futures contract. The contract, based on the harmonised index of consumer prices (HICP), was launched on September 19.
It is the exchange's second stab at an exchange-traded inflation futures product following the launch of a US contract in February 2004. Critics argue that that contract exposes users to seasonal inflation volatility because it is referenced to the quarterly US consumer price index (CPI) measure. They also argue that the exchange should have got more than just one market-maker – Barclays Capital – on board before launching the contract.
The CME looks to have responded to these criticisms, both by adopting the annual HICP index as the reference for the contract and by getting five investment banks to commit to providing liquidity ahead of launch.
Robin Ross, managing director of CME interest rate products, says the eurozone inflation swap market "currently lacks short-term, inflation-linked instruments. Our market-makers will help build and maintain liquidity, ensuring end-users can leverage the hedging benefits this new contract brings to the global market".
The CME HICP futures will represent inflation on a notional value of e1 million for 12 calendar months. As with CME eurodollar futures contracts, they will be quoted as 100 minus the annual inflation rate in the 12-month period proceeding the contract month.
"The new HICP futures will provide a much needed market for trading short-term inflation expectations," says Borut Miklavcic, Lehman Brothers' head of European inflation trading. "The instrument will not only enable derivatives users to hedge fixings risk, but will also allow for trading forwards on European inflation-linked bonds, and could kick-start trading in inflation-linked bond options."
Barclays teams up with HFR
Barclays Capital and HFR Group are offering transparent pricing for hedge fund-linked tradable options. Based on the HFRX Global Hedge Fund Index, Barclays Capital will offer a two-way market in European call options to its institutional clients and counterparties. HFR is a Chicago-based provider of hedge fund data, research, indexation and asset management services.
Until now this segment of the fund-linked market has been conducted on a by-appointment basis, giving investors little opportunity to compare prices easily. The launch of these options should add transparency and liquidity to the fund-linked derivatives market by providing investors with real-time pricing and standardised product terms, say the two firms. "Until now there has been no transparent price source for alternative investment-linked option products," says Antti Suhonen, head of fund-linked derivatives structuring at Barclays. "By making pricing public, we are adding transparency to a market that has been somewhat opaque and allowing more investors to invest in these products."
Indicative pricing will be available during London market hours on both Bloomberg and Reuters. The options will be available in euros, US dollars, sterling, yen and Swiss francs. There will be a minimum dealing threshold of 500 contracts, or $500,000, which initially will have maturities from one to five years. Additional maturities and strike prices will be added subject to market demand.
US firms will survive bursting of housing bubble, says S&P
Research by Standard & Poor's suggests that most US mortgage firms would be able to withstand the bursting of a US housing bubble, despite the greater credit risk associated with current mortgage portfolios.
The rating agency applied a loss given default (LGD) stress test to the rated universe of firms – including US banks, thrifts and specialty finance companies. The stress test results showed that only six firms had a net income loss greater than their first-quarter earnings in 2005. S&P used this measure as a gauge of capacity from an earnings perspective to withstand a spike in credit losses.
Standard & Poor's says that while it expects housing price trends to be regional and driven by local economic and unemployment factors, rating actions will ultimately be based on the degree of credit and interest rate risk banks are willing to accept in their portfolios, and how well they are able to manage these risks.
Adjustable-rate mortgages accounted for around one-third of single-family mortgages originated in the US last year. These products, combined with the growth in home equity lines of credit products and increasingly lax underwriting standards, means that US mortgage portfolios are becoming more credit risky (see pages 26–27).
TriOptima tears up $127bn in CDSs
Scandinavian service company TriOptima's latest software run on credit default swaps (CDSs) for the largest US and European companies has resulted in the tearing up of swaps with a notional value of $126.6 billion.
Previous runs this year have dealt with CDSs from various sectors in the US and Europe, including telecoms, indexes, automobile and high-yield CDSs. Since January, TriOptima has torn up over 71,000 CDSs with a notional value of $1.23 trillion and a mark-to-market value of $23.9 billion.
"Dealers recognise that terminating trades is a valuable tool for reducing the operational backlog that has accompanied the explosive growth in the credit derivatives market," says Brian Meese, chief executive of TriOptima.
As in previous tear-up cycles, 18 institutions, representing about 90% of the total inter-dealer market, took part in the exercise. The tear-ups represent 19% of the total CDS notional volume in the market at the end of last year, according to figures from the Bank for International Settlements.
Van Hedge expects hedge fund AUM to double
Van Hedge Fund Advisors, the Nashville, Tennessee-based hedge fund adviser, projects that hedge fund assets under management will grow to $2 trillion by 2009. Current estimates put the size of the hedge fund industry at just over $1 trillion.
The adviser says almost 40% of investments in hedge funds are made via funds of funds. Broad market-based strategies such as macro and futures currently have the most available capacity. Between 1998 and 2004, macro strategies had a 16.4% compound annual return, while futures-based strategies had a 17.9% return over the same time period.
Beyond established strategies, hedge funds are becoming more active in energy, private equity and real estate. The hunt for unexploited profit opportunities is also prompting funds to enter into more unfamiliar territory, including middle-market lending, asset-backed financing, exchange-traded funds and reinsurance.
George Van, chairman of the hedge fund group, says his firm's research demonstrates that "statistics belie the widely-held belief that hedge funds generally use large amounts of leverage".
Van's analysis shows that 20% of hedge funds are not leveraged, and 50% use leverage equivalent to less than 100% of their equity. Among the most highly leveraged funds are those employing macro and market-neutral arbitrage strategies; 60% of these funds had a leverage of two times or higher.
Structured products in the spotlight
Concerns over the mis-selling of structured products to investors in the US have prompted the National Association of Securities Dealers (NASD) to issue guidelines to ensure members fall within the scope of sales practice codes.
The guidelines target dealers that are selling structured products linked to either currency, a single security, a basket of securities, an index, commodities or debt. "This guidance is intended to advise firms about how they might go about making sure they are not in danger of violating the sales practices because of some confusion, perhaps about how to treat these products," says a spokesperson for the private sector body in Washington DC.
The guidelines were issued to members in mid-September after the NASD conducted a review of its members that sell structured products. The assessment revealed that some of its members may be falling short of meeting 'sales practice obligations' when selling the products, particularly to retail clients. These obligations include providing fair, balanced and accurate disclosure in promotional material, and complying with suitability obligations.
"We have determined, at least for the time being, that the existing regulatory structure and requirements we have in place provide the necessary tools to address firm conduct, and for them to address their own conduct with respect to the sale of these products," says Gary Goldsholle, associate vice-president and associate general counsel, office of general counsel, regulatory policy and oversight in Washington DC. "Given there were some shortcomings in certain areas, we thought it would be helpful to guide firms' conduct towards where we believe it should be."
The NASD uses a broad definition of structured products as securities derived from, or based on, a single security, a basket of securities or an index. The products can offer either full protection of the invested principal, or limited or no protection of principal.
One head of structured products says some of the recommendations are unnecessary: "I like best practices but I think this goes over the line and I'm not sure it was well thought-out or well run."
Isda protocol tackles derivatives backlogs
The world's major derivatives dealers have signed up to the International Swaps and Derivatives Association's long-awaited 'Novation Protocol', which seeks to facilitate the transfer of existing trades to third parties.
The new protocol is aimed at reducing the backlogs and uncertainty associated with the transfer of exiting derivatives positions to third parties. Until now, assignment trades have required the written consent of the remaining party before its counterparty could assign a trade to another dealer or institution. The new protocol simplifies this requirement to an electronic communication between the parties involved. The protocol will initially apply to credit and interest rate derivatives trades, with a view to extending it to other derivatives products in the future.
"This protocol addresses directly an area on which regulators and policy makers have focused their attention. It is a major step in achieving counterparty certainty," says Jonathan Moulds, chairman of Isda and head of international markets at Bank of America.
New York-based Isda has sponsored a series of meetings this year, bringing together business, legal and operational staff from both buy- and sell-side institutions to address some of the mounting problems in derivatives confirmations, particularly in the fast-growing credit derivatives market. The association has supported the development of automated confirmation solutions, such as Financial products Mark-up Language, the industry communications standard.
The backlog in derivatives confirmations has also raised alarm bells at the UK's Financial Services Authority (FSA) and the New York Federal Reserve. The FSA sent a letter to chief executives at the major investment banks in February, warning them about the scale of the problem. Meanwhile, the New York Fed met with 14 Wall Street banks, along with representatives from the Securities and Exchange Commission and the German, Swiss and UK financial regulators, on September 15 to discuss the problem.
The following banks and most of their various trading entities have so far signed up to the new protocol: Banca Caboto, Bank of America, Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Nomura, Standard Chartered, Royal Bank of Scotland, UBS and Wachovia. Isda says it expects this list will grow in the coming months.
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