Risk Awards 2016
The inflation derivatives business appears to be specifically designed to annoy bank capital managers. On the one hand, corporates demand long-dated, uncollateralised swaps, which generate significant counterparty credit and funding costs; on the other, collateralised buy-side investors only want to see razor-thin spreads.
A bank wanting to stay in this market has a choice: price the full cost of capital but risk losing out on trades; or price competitively with the hope of generating more profitable business down the line.
Following its strategic review in 2014, Barclays has staked its claim firmly on the former: it believes charging the full cost of capital is the only way to allow the bank to sustainably run a business it claims is "in our DNA".
"We quote collateralised long-dated inflation trades, and we quote uncollateralised. However the latter are more expensive, and we are very clear and upfront with our clients about that," says Nat Tyce, co-head of macro trading at Barclays in London.
We invested a lot of time internally in terms of resources and technology to allow each salesperson to change their mind-set, from immediate and current opportunities to look also at the long-term impact of trades
Marco Moretti, Barclays
Tyce says the inflation market is in transition, with some banks such as Barclays pricing in all the capital effects, and others only including a portion.
"There are some trades where others are going to be more competitive because they have not addressed these issues in such a timely manner as we have. And there are various factors we look at. We look at things like the portfolio effect and the probability of restructuring, but the reality is for anyone to put in place a very long-dated derivative – collateralised or uncollateralised – where the trade's on the books for life, the cost of those trades has to go up," he adds.
Marco Moretti, inflation product manager at Barclays, says a lot of effort has also gone into changing the way the sales team thinks about the business.
"We invested a lot of time internally in terms of resources and technology to allow each salesperson to change their mind-set, from immediate and current opportunities to look also at the long-term impact of trades," he says.
This has ruffled feathers on the buy side, with some firms complaining Barclays has effectively bowed out of the market for long-dated trades.
"Barclays has been less worried about the fact they aren't doing that client business. Others won't price defensively as they will lose the buy-side franchise – but Barclays is thinking ‘if I don't win it and it's unprofitable business then I'm not bothered'," says a trading source at one London-based buy-side investor. A source at one asset manager says he no longer trades with Barclays at the long end.
When pressed, both concede Barclays is doing the sensible thing.
Tyce compares Barclays' stance on capital pricing to the way the market's views evolved around trades with one-way credit support annexes (CSAs), where only the dealer is required to pay margin if it's out-of-the-money. In 2011, dealers realised trades with these collateral agreements had extra embedded funding costs, but many did not price it in, in order to stay competitive.
"We did a lot of work to educate clients about these funding effects from one-way CSAs," says Tyce (pictured). "There was a period of time when that inevitably led to others being more competitive. But we felt we were being transparent and were pricing appropriately. We saw in those cases that others came into line with that view, it just took them longer to get there."
Barclays' continued clout in the inflation business was shown when it landed the duration manager role on the UK Debt Management Office's tap of its 2068 index-linked gilt in September last year, which it issued for the first time in 2014. With a per-basis-point interest rate sensitivity of around £22 million ($31 million), it was the largest duration event of the year.
As duration manager, Barclays acted as counterparty to the other syndicate members for the so-called switch orders that come from investors wanting to move out of their current points on the curve to the 2068 linker.
Apart from the prestige of the role, it had a specific benefit. With inflation-linked bonds trading at a discount to nominal bonds, some clients have looked to change their inflation hedging strategy from being swap-based to owning linkers on asset swap.
With Barclays' duration manager role giving it access to a range of gilt linker maturities, it was able to help clients make this shift. As an added bonus, it also allowed the bank to unwind some of the capital-intensive swap trades it had in its non-core portfolio.
"Back in 2014, we set up the Barclays non-core unit, and that obviously has a large portfolio of inflation swaps and we're committed to unwinding those," says Sukhjeet Atwal, head of inflation trading for Europe at Barclays in London. "One of the ways in which we were able to get clients into this asset swap was for them to unwind some of those inflation swap positions and to take on some of the switches we got from our role as duration manager."
With the non-core clients moving into linkers, Barclays was given a significant amount of inflation swap supply to provide to the market. It handed some of the supply to its client base, with the rest going to the interdealer market.
By transferring the accretion payment to the noteholders, the banks get complete capital relief on that future cashflow. Same with the real-rate flows out to 2063 – those are again very back-ended and due from the client to the banks, representing credit risk
Caroline Ellis, Barclays
Uncollateralised and capital-intensive trades at Barclays are handled by a central client solutions desk, which was created in 2014 to come up with alternative trade and collateralisation structures to cheapen the capital costs of new and existing swaps. The desk worked with the inflation team to play the leading role in arguably the most complicated deal in the inflation market in 2015: the Yorkshire Water inflation restructuring.
Following a portfolio restructuring in 2012, Yorkshire Water had £1.29 billion notional of swaps allowing the utility to fix revenues linked to the UK retail prices index (RPI). These uncollateralised trades require a significant inflation-linked accretion payment by the utility at maturity, generating large funding and credit valuation adjustment costs for banks.
Of this portfolio, 35%, or £452 million, had mandatory breaks in 2018, 2020, 2023 and 2025. These allow banks to cut the capital and funding costs of the trade by only pricing up to the point of the break – but also give banks a way out of a trade if it becomes too painful, and are often used by banks as leverage to renegotiate terms.
With real rates at all-time lows, the company's entire swap portfolio was just over £2 billion out-of-the-money as of March 31, 2015, according to its annual report. As the swaps were ranked super-senior in the utility's financing structure, rating agencies and creditors were keenly aware of the upcoming breaks, and wanted a solution to rolling them ahead of time to avoid a liquidity event.
In May 2014, Yorkshire issued a request-for-proposal through which 14 banks pitched to restructure £160 million of the swaps with breaks. Barclays was selected as the lead structuring bank and joint placement agent, working alongside BNP Paribas and Morgan Stanley.
The restructuring comprised two parts: a repack via a special-purpose vehicle (SPV) for maturities out to 2063, and traditional break removals for shorter-dated swaps. This was the second SPV repack structure, after Electricity North West executed the first deal in 2012. This structure, completed in June, involved splitting the existing long-dated swaps, and novating the bulk of the accretion payments and real-rate coupon payment flows to noteholders via an SPV. Barclays ran the investor marketing process to find the end-investors, and retained the shorter-dated swaps along with the other two dealers.
"By transferring the accretion payment to the noteholders, the banks get complete capital relief on that future cashflow. Same with the real-rate flows out to 2063 – those are again very back-ended and due from the client to the banks, representing credit risk," says Caroline Ellis, head of client solutions desk trading at Barclays in London.
The end result was that the original dealers were no longer sitting on hugely in-the-money, long-dated uncollateralised positions, and Yorkshire did not face the 2018 mandatory break and its related repricing and termination risks. The investors, meanwhile, got exposure to RPI-linked cashflows, plus an illiquidity premium due to the unique nature of the notes.
Adrian Hunt, group treasurer of Yorkshire Water in Bradford, is full of praise for Barclays' role in the deal. "I thought they were top notch. Really good quality of advice as well, while maintaining their independence. A deep knowledge, and very innovative. There were numerous hurdles and we were very pleased we chose Barclays," he says.
On the flow trading side, Barclays has a very strong position in the short-end euro inflation market, but faced a challenge this year from falling oil prices, which moved from $55 per barrel in January 2015 to $35 by the end of 2015. Arguably energy price movements are the most significant driver of very near-term expectations of inflation, with the difference between European inflation excluding energy, and headline inflation getting as wide as 1% this year.
As a result, Barclays has increasingly used Brent futures to hedge the bulk of its short-term European inflation risk, and gasoline futures to hedge the equivalent in the US, when markets are volatile and inflation liquidity is harder to find. The correlation is by no means 100%, but according to Atwal it captures the lion's share of energy-driven moves in short-term inflation.
"You can't really have a functioning short-term inflation offering to your client base without having an active and robust management framework around energy. Effectively, if you're trading short-term inflation, you're trading energy," says Atwal.
Elsewhere, Barclays put together a programme of trades for a southern European bank, which had liabilities linked to a domestic consumer price index (CPI). The counterparty bank had hedged the liabilities by owning assets linked to European inflation, creating a basis risk. Barclays sourced the domestic CPI from its client franchise, and swapped the client out of its European-linked flows.
Absa, Barclays' subsidiary in South Africa, was also involved in the solar power industry, where the feed-in tariffs are linked to domestic CPI. The bank assisted on two 18-year CPI-linked funding deals for two separate South African projects, recycling the inflation risk to its institutional client base.