01 Nov 2010, Richard Jory, Structured Products
BNP Paribas has dealt with regulation, offered products to deal with inflation and navigated a path made more complicated by regulation.
The insurance industry lies at the heart of much of the interest rates business over the past 12 months, and BNP Paribas was prepared as Solvency II heightened concerns over funding issues, liquidity concerns and credit constraints.
Insurance companies have long-dated liabilities to policyholders but only short-term assets. Addressing the mismatch and switching those short-term assets (generally bonds) easily becomes complicated: as rates have fallen, selling these assets is likely to produce a profit with any sale deemed to be bringing the investment to an end, requiring a sharing of profits with policyholders.
“The companies could do swaps as an overlay, but there is an accounting issue where they have to record the profit and loss in their revenues at the end of the year,” says Vincent Berard, head of interest rate and custom index structuring for Europe, the Middle East and Africa (Emea) at BNP Paribas in London.
“But this is a long-term hedge and they do not want to take profits out. So the proposition was to buy bonds forward for when the short-term bonds mature,” says Berard. “They are government bonds, so it’s good quality paper, enhanced by the fact that this is a strip – a bond which doesn’t have any coupons – so the maturity is longer. You get a very high yield because it is a strip bond and the curve is steep – you get a nice pick-up, of more than 1% on a bond that is 20 years.
But someone needs to buy the bonds and keep them. “We buy the bonds and then do a collateral exchange - we give back the bonds to the insurance company in repo and they give us cash,” explains Berard. “We take the cash and we swap it for much more liquid collateral, like French government bonds, which is much easier to finance in the repo market. It makes no difference to his cash position or economic returns. We buy the strips with the cash given to us in repo. The strip should be French or German government bonds.”
BNP Paribas has continued to provide liability hedges using its Galileo index. The bank did a swap with one client – in this case a treasury – where the swap allows it potentially to reduce the cost of its debt. “For example, if it is paying Euribor, we pay it instead and it pays a fixed rate minus a discount linked to the index,” says Berard. “If the index performs, the client will not pay the fixed cap rate but a lower rate. If it doesn’t, the funding will be fixed at the cap rate.”
To keep the rate below a regulatory cap, the bank combined trades. “In this case, we combined the index trade for the next 10 years (when the rate would be the cap minus the discount), and at the end of the 10 years we added a swaption which gives us the right to extend the swap for 10 years at the same level as the cap,” he says.
More innovation came with the adaption of the index and technique in South Africa. “The model works, we have a client who is excited and wants to buy it and distribute it,” says Berard. “We just hope that in the next deals, we will start making our money back. Sometimes it’s nice just to be the first on the market. But there is always a price to pay for that.”
“We worked with the fixed-income guys over six months to see if we could take Galileo and apply it to the South African market,” says Andrew Wolfson, head of Cadiz Alternative Investments in Capetown. “What came out was a combined ZAR strategy that took moving average, likelihood ratio to oscillators for enhanced performance with the intent of picking up signals in the South African interest rate market. Since March the strategy is up 92 basis points (bp) on a non-geared basis.”
The bank has developed its inflation expertise primarily on the structured side and has taken a big step forward in helping develop the German market. “You need to develop a two-way flow, so we did a big roadshow to German companies to see if we could get them to pay inflation embedded in some of their leases,” says Kara Lemont, head of interest rate and FX structuring, Emea at BNP Paribas in London. “We are doing the same in Turkey.”
And the bank has introduced inflation asset options. “A client has inflation-linked bonds on his balance sheet already on an asset swap basis: so he has a bond and a swap overlay where he swaps all the coupons of the bond and receives Euribor plus 230bp,” explains Nicolas Sagnes, head of inflation structuring at the bank.
“We bought an option from the client – a right to receive from the client the inflation-linked bond on an asset-swapped basis at 200bp. The option could be exercised in December this year. If the asset-swap spread on the linker tightens below 200bp, we will exercise the option and the client will sell the inflation on an asset-swap basis at 200bp [which is where the client wanted to take profit]. If the option expires out of the money, the client will have benefited from the premium."
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