Inflation Derivatives House of the Year - Barclays Capital

The Risk Awards 2007

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Just a year ago, there was talk of crisis in the UK inflation market. Since the adoption of accounting rule FRS 17 in 2005, UK companies have had to calculate their pension liabilities using a discount rate based on bond yields. Under pressure from regulators to eliminate deficits, pension funds had been piling into long-dated nominal and inflation-linked assets en masse.

The problem was, there simply wasn't enough supply. Corporate inflation issuance had more or less dried up, and while the UK Debt Management Office (DMO) had issued its first 50-year nominal gilt in May 2005, followed by the first sovereign 50-year inflation-linked bond four months later, it didn't even come close to satisfying demand. On January 18, the yield on the 1.25% 2055 index-linked gilt touched a record low of 0.38% - and with the DMO choosing not to substantially increase its issuance of 50-year gilts, the situation didn't look like it was going to get any better.

Twelve months on, the picture is completely different. Recognising the opportunity presented by low yields, UK utility companies have flocked into the inflation market, looking for a hedge for their inflation-indexed revenues. More than £4 billion of mostly inflation-linked bonds has been issued by UK utility companies over the past year, providing an essential source of inflation for the pension sector and substantially adding to the depth and liquidity of the UK market.

Barclays Capital has been at the forefront of assisting utilities to access the UK inflation market, executing close to 50% of the deals transacted this year. They include two tranches of inflation-linked bonds with 40- and 45-year tenors totalling £150 million for Wessex Water in July, plus deals for Anglian Water, Northumbrian Water and Thames Water.

"There was an opportunity for UK utilities and corporates that had inflation-linked assets to take advantage of those and borrow at very low rates, and so we went aggressively after these companies because we thought there was real value for them," says Benoit Chriqui, director and head of European inflation trading at Barclays Capital in London. "In this environment, where there was a need to source inflation, we felt this was a perfect answer to the liability-driven investment crisis that we had last year."

Another source of inflation this year has been private finance initiatives (PFIs) in the UK, and again, Barclays Capital has been a key player in this market. In June, the UK bank acted as lead manager on £352.2 million of index-linked bonds due in 2038, issued by special project company InspirED Education (South Lanarkshire) to fund the construction of 17 new secondary schools and the refurbishment of two others in South Lanarkshire, Scotland - then the UK's largest schools PFI project. The AAA rated bonds were guaranteed by XL Capital Assurance, a New York-based monoline financial guarantee company.

For this transaction, Barclays Capital offered investors either conventional gilt-based or Libor-based bids into the bond book-build, with asset swaps executed automatically for successful Libor bidders. Typically, investors have had to execute the asset swaps after the transaction has closed.

"The investors this year have mostly been Libor investors, who always look to asset swap the index-linked assets to create Libor assets. Pension funds, which historically were the usual investors, are mostly interested in the inflation side of it, but Libor investors are just interested in the credit element - in having cheap AAA assets," explains Chriqui. "Automatically executing the asset swap was a way of reducing the risk for the Libor investors, and helped give the issuer the most efficient cost possible."

That's not to say demand for inflation-linked assets among pension funds has slowed this year, and leading asset managers say Barclays Capital has been a key player in the liability-driven investment market. "They are undoubtedly in the top tier of inflation swaps counterparties," says one London-based asset manager at a large UK-based investment management firm. "They are equally happy to write retail price index (RPI) or limited price inflation (LPI), and a number of second-tier businesses can sometimes struggle with the LPI side. Barclays has a good natural source of inflation through its utility and PFI customers, and that does enable it to take inflation risk on to its books because it knows there is an ongoing pipeline."

In fact, the market has developed beyond RPI and LPI floored at 0% and capped at 5% (LPI(0, 5)) - trades that were popular in the UK inflation market in 2005. This year, the leading inflation dealers transacted hedges with a wider variety of strikes, enabling pension firms to more closely match their liabilities. For instance, Barclays Capital assisted one UK company in hedging the entire asset/liability real rate exposure of its pension scheme. The transaction, which involved aggregate inflation swaps on a real notional of more than £400 million, bundled RPI, LPI (0.5), LPI (0,3), LPI (3,5) and LPI (0, infinity).

"There was a move towards more precise hedging this year, and you now have LPI (0,3) and (3,5) to match specific liabilities. The proximity to the forwards of the 3% strike LPI means these deals are more complicated to hedge, but it also creates end-user interest in the volatility market for inflation, which actually helps push the market into more sophistication," says Chriqui.

Indeed, the inflation market more and more resembles the nominal market, and Barclays, along with a handful of other players, now quotes on non-linear products, such as swaptions and, in the US, Tiptions (swaptions on US Treasury inflation-protected securities). "Overall, there is an increase in players in the inflation market, and a couple are active in the volatility market in the UK, Europe and the US. At the same time, there is growing interest in inflation as an asset class from pension funds, corporates and hedge funds," says Eric Bommensath, New York-based head of fixed income at Barclays Capital. "A lot of the modelling technology is being imported over into the inflation asset class, so it is progressively derivatising. And I think next year we should have more hybrid or exotic-type solutions for end-users."

Barclays has also been active in the structured notes market. One of the most popular trades of last year was a note that had a leveraged payout based on the relationship between European and French inflation. The rationale for the product was an anomaly in the euro-French inflation spread. Historically, French inflation has traded below European inflation, but strong demand for from Livret-A hedgers - regulated French savings accounts with an explicit link to inflation - had pushed the French inflation curve above that of Europe by about 10 basis points.

The UK bank structured a product that paid a fixed rate plus six times euro minus French year-on-year inflation, capped at 7% and floored at zero, selling around EUR165 million notional of the product. Strong investor demand for this product, along with hedge funds that transacted forward starting swaps based on the anomaly, has subsequently driven the French inflation curve back below that of Europe. "This is essentially a derivatives solution that helped correct a structural imbalance in the market, as there was no natural supply of French inflation. It also helped foster liquidity in the French inflation market," says Ralph Segreti, head of inflation products at Barclays Capital in London.

Meanwhile, Barclays Capital worked with Samson Capital Advisors, a New York-based fixed-income investment manager, to launch a tax-exempt fund offering US consumer price index (CPI) protection. The fund invests in municipal bonds, which are exempt from federal taxes, as well as CPI swaps and floors, to provide the exposure to inflation. Samson wanted leveraged exposure to inflation, and so opted to receive $20 million of inflation protection for every $5 million invested in municipal bonds.

"The risk to that strategy is if inflation falls to such a low level that the collateral portfolio of municipal bonds is insufficient for the loss on the CPI swaps," explains Ben Thompson, principal at Samson Capital in New York. "That's why we bought floors on the CPI swaps, and the strike was set at a level to be sufficient to compensate for any significant declines in the CPI component of the portfolio."

Barclays worked with Samson to determine the optimal strike and tenor of the fund, and the bank executed around 50% of the CPI swaps and floors. The fund closed in June, and raised just under $100 million. "This fund is unique in its tax efficiency, time horizon and amplified CPI exposure, and it is one of only two strategies that I know of that marries CPI derivatives and municipal bonds," adds Thompson. "Barclays was at the forefront as to how we crafted our documents and our leverage multiples for the CPI swaps and placing the floors. It sought to understand what we were doing and presented ideas to enhance the offering."

But it's not just the key US, Europe and UK inflation markets that have been the focus for the bank. Barclays has also extended its presence in emerging market inflation over the past year, particularly in Latin America and South Africa. The bank has executed around $1.25 billion in total return swaps and credit-linked notes linked to Brazilian inflation, enabling real-money and hedge fund investors to access the market; has traded inflation swaps in Argentina; and has sold a US inflation note, quantoed into Colombian pesos, to a Colombian insurance company.

"Most of these countries have localised pension needs and are waking up to their liabilities," says Segreti. "We traded real-rate swaps in South Africa, inflation swaps in Argentina, and we are looking to get more involved and build that space because investors there need those solutions. I think it is something you will see grow next year."

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