The inflation market used to be a calm place, littered with sure things and safe bets. Prior to the crisis, central banks had been doing a solid job of keeping inflation steady and, as a result, inflation-linked products traded in a predictable way. As 2008 wore on, that began to change: uncertainty about the future path of inflation injected unprecedented volatility into a market that was never liquid at the best of times. Liquidity thinned out even more in the last quarter of that year, with many investors, hedge funds and banks retreating to the sidelines.
Those banks that remained did well – the three dealers that made it on to this year’s shortlist all say they are expecting record profits for the business in 2009 – but the winner, Barclays Capital, distinguished itself by seeking to fix a market that was close to broken.
“If you look at the history of Barclays Capital, it is intertwined with the history of inflation markets,” says Ralph Segreti, global inflation product manager at the bank in London. “The first market we were ever great at was inflation, the first product we ever put the full force of the firm behind was inflation. And as inflation markets grew, so did our relationships with clients and so did the firm as a whole. So, if we didn’t support the market during the crisis, who would?”
That support took a number of forms. The bank helped corporate issuers that were shut out of the public inflation-linked bond market, advised sovereigns on how to keep their linker markets open and functioning, and provided much-needed liquidity to investors and other market participants at a time when some trading desks chose to sit on their hands.
In one transaction, believed to be unique for the market, Barclays Capital provided £200 million in inflation-linked funding for two UK utility clients when the sector’s usual source of inflation had been choked off. Traditionally, utilities have been able to enjoy cheap inflation-linked financing by issuing debt wrapped by monoline insurers – investors would then buy the bonds and trade them in asset swap format. That model died when monolines ran into trouble and counterparty-conscious asset swap investors shied away from the market. But utilities still craved inflation-linked funds and Barclays Capital stepped into the vacuum, drawing on the structuring and balance sheet resources of the Barclays group balance sheet to offer inflation-linked loans. “It was the only source of inflation-linked funds any utility was able to obtain during the market dislocation, and demonstrated Barclays Capital’s deep understanding of the credit and inflation markets,” Segreti says.
Understandably, the clients were grateful: “The inflation award is well deserved. We were delighted when Barclays came to us with its index-linked loan solution at a time when access to such funding was very limited. The fact the bank was able to provide a solution when others were not demonstrates its strength. Getting access to a new market for inflation-linked debt was incredibly important to us given our ever-increasing need for debt funding,” says the group treasurer at one of the utilities.
Loans might seem like a fairly simple solution, but Segreti points out no bank was keen to tie up its balance sheet in the period following the Lehman Brothers bankruptcy when the two loans were made, and the transaction also required some thorny accounting issues to be resolved. “Working closely with clients from start to finish, it took Barclays Capital three months to finalise the loan structure,” says Segreti.
There was also drawn-out wrangling over another UK deal: a consortium of construction companies including Skanska needed £1 billion to finance their work on the widening of the M25 motorway in the UK, and had to turn to a club of 16 banks in the absence of other options. Barclays was one of three banks chosen to execute the inflation hedge needed for the bank debt and the inflation-linked revenue stream the consortium would be receiving, but both the structure of the swap and the practicalities involved in getting 16 banks on the same page made it a ticklish process. Barclays Capital played a key role in holding everything together. “Barclays conducted themselves in a professional manner throughout the close of the M25 project. The depth of ability of the derivatives team and their support on the documentation, structuring, execution and novation of the interest rate and inflation swaps was central to achieving financial close. The successful completion of the novation, given the number of banks involved, was exemplary,” says James Butters, head of project finance at Skanska, speaking on behalf of the M25 project consortium, Connect Plus.
Other, larger issuers also had a hard time. Thailand called off plans to issue an inaugural inflation-linked bond in the fourth quarter of 2008, and Japan’s linker issuance programme hit a speed-bump at the same time, when post-Lehman Brothers deleveraging abruptly stifled demand. Behind the scenes, Barclays Capital worked hand-in-hand with a number of sovereign issuers, providing advice, research and – in one case – even escorting debt management officials from one problem-hit country to meet their counterparts in another market so they could learn about their experience. The bank agreed to discuss this work on a confidential basis, but wouldn’t comment on the record.
“In terms of maintaining and repairing markets, we’ve worked quite actively with both issuing authorities and regulators to help them figure out how to deal with the crisis and pull liquidity back into their markets,” says Segreti. “We’ve also done a lot of work around new issuance – we’ve been working with a couple of different European countries that are talking about issuing. We have bankers in mainland China, Australia and eastern Europe trying to find ways to source inflation and develop the markets there.”
Other support was more mundane – staying open for business and providing reasonable quotes – but no less of a high-wire act, says Benoit Chriqui, the bank’s London-based head of European inflation trading: “We stayed open on every asset class. There was some widening of bid/offer spreads on our part so we might have lost some business early on, but while other banks were very aggressive and dropped out of the market, we were always trying to find the balance between providing liquidity and charging appropriately for it.”
Clients say the bank found that balance. “We did about €6 billion in inflation trades this year and Barclays is our top counterparty. It is committed to the market. We had trades to do at the end of 2008 and it was the only market-maker to show consistent prices in Treasury inflation-protected securities (Tips), for example,” says Guillaume Delrée, head of inflation trading at Credit Industriel et Commercial.
On the other side of the Atlantic, Bob Treue, founder and portfolio manager at New Jersey-based hedge fund Barnegat Fund Management, also offers praise: “I’d say we did about $3 billion in inflation swaps this year and two-thirds was with Barclays Capital. When others imploded they stopped trading, so Barclays stepped forward and took a lot of market share.”
The US market was one of the bank’s big strengths. Segreti claims Barclays averages about 25–30% of the client market for Tips trading – a figure that spiked up to more than 45% in the fourth quarter of 2008 as other banks sat on the sidelines.
That might make it sound like all Barclays Capital had to do was pick up the phones and let business roll in. But quoting confidently and consistently wasn’t simple, says Chriqui: “All the correlations the market had previously counted on broke down massively. Every single one of the areas that dealers were warehousing diverged.”
He ticks off two of the key dislocations: the stable 5–10 basis point spread between inflation swaps and inflation-linked bonds meant banks had been able to hedge swaps with bonds for years prior to the crisis. But when banks started to sell linkers as part of an effort to reduce their balance-sheet size at the end of 2008, it forced hedge funds to unwind their own long positions, pushing some spreads out by more than 100 basis points. In contrast, other risks had traditionally been left unhedged, notably the big exposure many dealers had built up by flooring inflation-linked structured note coupons at 0%. Deflation seemed such a remote risk and volatility was so low, the floors were sold for practically nothing. But as inflation sank during the third and fourth quarters of 2008, the floors increased massively in value, becoming as much as 20 times more expensive at one point.
Some market participants claim Barclays Capital was badly wounded by the second of these dislocations and took a decision to fold its inflation option trading into its rates options team as a result. Segreti and Chriqui deny that. They acknowledge the firm had exposures but say they were actively managed and addressed in a much more aggressive fashion than many of their competitors: it is understood the bank was one of the takers when Goldman Sachs, the main source of supply at the time, started actively selling inflation volatility. As for rumours about changes in its organisation, Segreti says: “While there was a reorganisation within the inflation business, it had nothing to do with the options desk and was not done in reaction to the performance of the business during that period.”
Chriqui suggests another motivation for the rumours: “Our hedging activity might not have been popular among other banks. Because we focus on recycling risk, it allowed us to reduce our position to a manageable size at reasonable levels well before volatility peaked, and in turn allowed us to stay open for clients. Other banks also had the exposure, but were reluctant to buy any volatility back because they viewed it as too expensive, and were also unable to sell it because they already had a big position, so basically shut down for business.”
The first of the two dislocations may have been bewildering, but it also became a key flow for inflation desks in 2009. The wide spreads on inflation-linked bonds meant they became incredibly cheap on a relative-value basis, attracting a host of new participants to the market who typically bought exposure to the bonds via asset swaps (Risk November 2009, pages 58–60). Some dealers estimate up to $40 billion notional of linkers were traded in asset swap format from the fourth quarter of 2008 until well into 2009, when the wave of buying finally restored some sanity to the market.
“This was a significant flow for us this year, representing roughly a third of our client trades – a higher percentage than in previous years,” says Chriqui.
All in all, it’s been a year full of surprises – and not all of them have been bad. “The year went much better than expected – better than anyone expected,” says Segreti. “There were a lot of challenges, a lot of uncertainty about the path of inflation – and when some people are expecting a deflationary spiral that will lead to depression. I think it’s a real accomplishment for an inflation-linked business to perform as well as this business has.”
The week on Risk.net, December 2–8, 2017Receive this by email