Inflation Derivatives House of the Year - Royal Bank of Scotland

Risk Awards 2008

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Pension funds looking for inflation-linked paper were let down by government issuers last year. The UK cut its programme for the 2007 fiscal year to £15 billion from £17.2 billion. Scandinavian issuers also trimmed their volumes, and some countries that had been expected to issue long-dated linkers - such as Germany - didn't come to market at all. So, investors were overjoyed in April when Network Rail stepped into the breach, announcing plans to issue around £10 billion in new inflation-linked debt over the next two years - a programme that would make the company by far the biggest non-government issuer of inflation bonds.

Most companies would have been laughed out of the market if they had announced issuance on that scale. What made it possible was a recently renewed long-term debt guarantee from the UK government, creating an opportunity for Network Rail to sell its debt as quasi-governmental paper. But the company still needed a bank to buy that story and take it to investors - and the inflation team at Royal Bank of Scotland (RBS) was the first to catch on.

"Earlier this year, we decided that we needed to move dramatically from conventional issuance and into inflation-linked debt," says Fred Maroudas, director of funding at Network Rail in London. "So we set about developing something that only a few sovereigns have ever tried before - an index-linked programme that combines size, credit quality, liquidity and regular, predictable supply. RBS immediately grasped that what we were proposing filled a gap in the market, and put its full weight behind us to help deliver it."

Famished investors devoured May's £1 billion 30-year issue - the order book was left open for a day and a half, during which time £1.9 billion in orders were placed, enabling the bonds to price around 25 basis points above comparable gilts. Further issues of £500 million arrived in July and September.

"Network Rail had a letter of comfort from the government, which makes its bonds virtually the same as gilts. We told the company it should start thinking of itself as a benchmark issuer," says Chris Thomas, co-head of inflation trading at RBS in London. To help get that message across to investors, RBS committed to treat the Network Rail bonds as though they were government bonds in terms of liquidity - clients can execute trades automatically via the bank's Bloomberg screens. Other dealers soon followed suit, says Thomas.

It's no accident that RBS was quick to see the potential in the Network Rail programme. The bank has played a leading role in the wave of inflation issuance from UK utility companies over the past two years and acted as bookrunner for around 20% of the deal flow in 2007 - in the process, building up a hefty contact list of inflation investors. And, because almost all inflation-linked bonds end up being asset-swapped, the bank's share of the inflation swap market was also bolstered, says Thomas: "Our ability to stay close to the asset managers and do big blocks of utility business with the asset swappers means we had the best window on what demand was like. So when Network Rail came along, we had the confidence to tell them they could issue at that size."

The year hasn't all been plain sailing though - and one deal that should have been a feather in the bank's cap ended up attracting the wrong kind of headlines. Late in May, UK pub operator Mitchells & Butlers (M&B) had been planning a joint property venture that needed a group of banks to provide loans totalling £4.2 billion - one of the banks was RBS. For M&B to effectively risk-manage the deal, a jumbo inflation swap was also required, and RBS was one of two counterparties that split the transaction down the middle.

Unfortunately for M&B, shortly after the swap was concluded, the commercial mortgage-backed securities market ground to a halt, shutting off the lending banks' exit route and reportedly prompting them to change their loan terms. On August 2, M&B announced it would be shelving the deal "until debt markets have improved". Since then, the naked inflation hedge has moved heavily against M&B, which on November 29 announced a £180 million mark-to-market loss on the swap - equivalent to roughly 10% of the firm's revenues for the year. The company has said it will retain the hedges and use them to support an eventual refinancing of its property. M&B declined to comment for this article.

RBS refused to give specifics on the size of the hedge, but publicly available information on the planned deal suggests the swap would have had a DV01 of around £6 million. "From what we know, it was by some distance the biggest swap seen in the market this year," says an inflation trader at another bank. "But it was transacted without any noise. M&B's problem was the financing environment, not the hedge."

In the past, bonds, swaps and the occasional structured note have been the only story inflation dealers have had to tell, but the market has done a lot of growing up in the past 12 months. Thanks to the birth of an interbank market in inflation caps and floors, dealers and their clients now have more information about how to price optionality. For the first time, dealers have been able to offer investors relatively complex products such as range accruals, while inflation hedgers have started looking at their exposure as something that can be managed far more selectively.

"Lots of inflation-linked structured notes have embedded 0% floors, but that doesn't tell you much about other strikes and other types of option," says Christian Alibert, co-head of inflation trading at RBS. "There was a need for more complex products, but in order to get there we had to encourage a market at other strikes, starting with at-the-moneys and then filling in around there. That's been happening this year, and it's enabled us to respond to client needs rather than encouraging them to trade where we already see liquidity."

Few hedgers are interested in standard caps and floors - they have more idiosyncratic needs - but dealers are now able to take on these risks safe in the knowledge that they can shed some of the exposure in the interbank market, while clients can also refer to the pricing on caps and floors to get comfortable with the terms of more bespoke transactions.

RBS has benefited from this - Thomas says the business has seen its profits almost double year-on-year - but it has also worked hard to encourage the evolution of the options market. RBS is alone in publishing real-time inflation options prices on Bloomberg, a service it launched in March. Approximately 150 different market participants now have access to live bids and offers on four different inflation indexes, across strikes that range from -1% to +4%. Other dealers quote on request or mail out pricing grids to selected clients.

"We'd believed for some time that the market was ready for inflation options, so we sat down last year and decided we would show some leadership. The screens are a crucial part of that; they provide transparency and clients are now seeing the benefits," says Alibert.

So, when British Nuclear Fuels (BNFL) got in touch with the bank early last year to seek help with a thorny pensions-related exposure, the focus of the conversation moved quickly from a catch-all hedge to something more nuanced. BNFL wanted to buy protection against a fall in equities and real rates over a one-year period - after which time, the company's scheme will transfer to a new sponsor, with BNFL required to make up any shortfall.

However, the hybrid option solution initially proposed by RBS was too pricey for the company. Instead, the bank found that the terms of the scheme's transfer allowed the company to offset an expected increase of up to £15 million in mortality-related liabilities against any surplus a year later. BNFL agreed to sacrifice that potential upside in order to decrease the overall cost of the transaction. The result was a massive £270 million real rate swaption - bigger than all RBS's previous real rate and breakeven swaptions combined.

"The first hedge was a lot more expensive than we wanted," says Mike Davies, divisional finance director at BNFL in Warrington. "So, we looked for a trade-off between the exposure we had and the premium we were willing to pay. RBS was able to structure something that meant we got 80% of the cover we'd originally wanted, at 40% of the cost. Obviously, we were very happy with that."

As well as promoting the options market, RBS has also been keen to add more of an international presence to its traditional strength in UK inflation. The business had been adding staff overseas even before the ABN Amro merger was agreed, and the headcount is now set to increase further. In addition to the core team of 10 in London, RBS should be able to boast two traders dedicated to the US market and two more handling Japan, as well as one devoted to the Australian market this year.

The fruits of this global presence started to appear last year, with significant trades happening in all three of those markets, such as a $380 million US inflation index swap and $265 million Treasury-inflation protected securities trade that RBS executed for Aberdeen Asset Management in November. The bank also pulled off a two-dimensional hedge of Chilean inflation and foreign exchange risk for Chicago Bridge & Iron (CBI), a US company that has a contract to build a liquefied natural gas import facility in Chile's Quintero region. "RBS was very hepful," says John Masterson, director of financial derivatives at CBI in The Woodlands, Texas. "They had the patience to go through many iterations over a period of five months to make sure we reached the best solution."

As for this year, RBS is hoping to strengthen its position further. "You've got to be able to see the full circle of demand and supply in this market. We feel we're in a unique position to provide that," says Thomas.

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