Without intermediation, the inflation swap market would not exist. In general, corporates supply the inflation, and real-money investors such as pension funds buy it.
But in the UK utility space, where inflation swaps are long-dated, uncollateralised and often deeply in-the-money to dealers due to low real rates, playing that intermediation role comes with heavy counterparty credit and funding costs.
To tackle this, Morgan Stanley devised the inflation repack in 2012, transforming a utility’s inflation swap cashflows into coupon payments for real-money investors via a special-purpose vehicle (SPV). The US bank, however, has taken the structure to new heights in 2017: it not only executed three of the largest, most complex deals to date, it improved the structure to make them easier to execute. This has made Morgan Stanley the go-to house for repacks – even if the bank didn’t execute the inflation swap in the first place.
“There are some bits of this business that banks are the best place for: exotic products, the timing mismatch, the elements that make the accounting work – the very bespoke things. But there is a better place for the illiquid credit risk which normally we find to be these repacks,” says Guy Winkworth, head of European inflation and sterling rates trading at Morgan Stanley in London.
Zero-coupon inflation swaps linked to the retail price index were a popular way for utilities to fix their RPI-linked revenues before 2008. These trades require a large inflation accretion payment by the company at maturity, generating a big counterparty exposure for the dealer through the life of the trade.
In a repack structure, the inflation accretion payments are novated to the SPV, which routes the cashflows to real-money investors via RPI-paying notes.
One problem that has existed since 2012 was that the utilities, which are often structured as whole business securitisations (WBS), are not allowed to face an unrated entity such as an SPV. In past repacks, this has required a change to the WBS’s intercreditor documents – a painful, high-wire act that depends on investor consent – or a guarantee from a dealer.
Morgan Stanley changed the game last year in a deal with Thames Water. The utility refinanced a structured bond, originally arranged by the US bank in 2003, but wanted some of the debt to be in inflation-linked format. Morgan Stanley entered a £114 million notional overlay swap, maturing in 2058, in which the utility paid a real rate and received a nominal coupon from the US bank.
We operate a one-stop shop for the origination, structuring, distribution and trading of the transaction. So when we look at these transactions, we don’t have seven or eight people trying to contribute and get the business done. It’s really a very small, close-knit team that enables it to be executedChris Lipscomb, Morgan Stanley
Morgan Stanley split the swap, novating most of the inflation accretion payments to a Morgan Stanley-owned SPV, Sennen, and retaining the residual cashflows. The inflation element was fully accreting, though, meaning the noteholders – mainly pension funds and insurers – have to wait until 2058 to receive those flows as a bullet payment.
For the first time, this was done without having to make changes to the intercreditor agreement. Morgan Stanley declines to explain the mechanics, for competitive reasons.
Making things more difficult, the bond refinancing, swap execution and SPV repack were all executed on the final trading day of 2016.
“In my experience of capital markets transactions over 10–11 years, this is one of the ones I’m most proud of,” says Andrew Beaumont, group treasurer of Thames Water at the time and now group treasurer at Balfour Beatty in London.
“Morgan Stanley worked very closely with us and were very open in terms of how they evolved the transaction, and where the pricing points were. It was a complex process around legal structuring, tax and accounting,” he adds.
Chris Lipscomb, head of the derivatives solutions group at Morgan Stanley in London, says the key is the silo-free structure of the solutions team. Bankers in the team play both debt capital markets and derivatives structuring roles, and work with the credit sales team on distribution to help out with questions from investors.
“We operate a one-stop shop for the origination, structuring, distribution and trading of the transaction. So when we look at these transactions, we don’t have seven or eight people trying to contribute and get the business done. It’s really a very small, close-knit team that enables it to be executed,” he says.
Morgan Stanley’s reputation in this area is such that it has attracted interest from clients that hadn’t previously executed with the US bank but wanted to use their technology to move break clauses in deep out-of-the-money swaps.
One example saw the US bank novate in a number of in-the-money, long-dated, uncollateralised inflation swaps with UK-regulated water utility Anglian Water from the non-core units of another dealers.
The swaps were restructured by Morgan Stanley so the accretion payments were made periodically instead of at maturity. The trades were put into a repack structure and sold to three real-money investors, with the US bank retaining the residual cashflows. The deal was completed in six weeks, concluding in July.
Morgan Stanley declined to place the notional of the trades or the number novated on the record. Anglian Water’s 2016 annual report showed the utility’s RPI swaps were out-of-the-money by £561.2 million, and that the fair value of the positions would fall by £190 million on a 1% increase in the index.
Where [Morgan Stanley] is strong is taking challenges and being able to use really interesting solutions to come up with answersJane Pilcher, Anglian Water
The pay-as-you-go (PAYG) element of the trades placed a regular funding requirement on Anglian, so the company would need to issue debt to fund the payments when due.
This introduced interest rate risk at the time of the issuances. Morgan Stanley therefore provided a strip of pre-hedges on the interest rate component of the financing to pay for the future PAYG inflation accretion amounts. The notional of the trades depended on what the inflation accretion amount was at the time, so were structured as balance-guaranteed swaps.
Again, the trade was executed without having to amend Anglian Water’s intercreditor agreement.
“Where [Morgan Stanley] is strong is taking challenges and being able to use really interesting solutions to come up with answers,” says Jane Pilcher, group treasurer of Anglian Water.
The bank’s work wasn’t limited to the regulated utility sector. A third stand-out transaction saw it working with the UK’s public-service broadcaster, the BBC, to help smooth and fix the cost of purchasing its headquarters, Broadcasting House in London.
Morgan Stanley had structured a sale and leaseback arrangement with the BBC in 2003 to pay for the construction of the building. The rent on the lease was linked to inflation, but the BBC’s licence fee – an annual subscription fee paid by the public – was also linked to inflation, which cancelled it out.
However, the BBC’s charter renewal in 2010 took away the inflation link from the licence fee, giving the broadcaster an inflation exposure. While the 2016 charter replaced the inflation link, albeit to a different index, it was felt this could no longer be relied on.
They’re a strong vanilla shop and they’ve got good market share in cash linkers and swap productsDerivatives trader at an asset manager in London
The BBC also faced a large, inflation-linked lump sum payment in 2033 to acquire the building. It could not borrow to pay for this due to debt limits set by the UK government.
Rent was also considered above-market, as it included embedded building redevelopment costs, which would fall away after 2033 – meaning there was an unequal distribution of costs between different generations of licence fee payers.
Morgan Stanley broke the project down into phases. It first helped amend the existing lease to spread the 2033 lump sum payment over time, out to 2045. It then executed a swap with the BBC, with the corporation receiving limited price indexation – which is RPI capped at 5% and floored at 0% – and paid a fixed rate, to set its rental and purchase costs. This cut its rental costs by around £10 million a year.
“We were paying them their rent and building acquisition costs and they’re paying us back a strip of fixed cashflows. The profile under the swap was such that we were expecting to pay into that swap every year until 2033 and expecting to receive back under that swap 2033 out to 2045. As an uncollateralised swap, that’s clearly pretty intensive from a balance-sheet perspective,” says Morgan Stanley’s Lipscomb.
So, the US bank turned to its trusty repack solution. It took the 2033–2045 receivable cashflows – which had a present value of £319 million, making it the largest repack to-date – and novated them to Sennen, which issued notes to real-money investors. The notes, which don’t start paying coupons until 2033, have a slightly different payout than regular repack notes, as they pay fixed minus inflation, rather than just inflation.
This left Morgan Stanley paying the cashflows until 2033, however, with no back-end receivables, creating a significant in-the-money exposure for the BBC to the US bank.
Morgan Stanley found a way to mitigate this by looking at a swap it was providing to the BBC’s existing sale-and-leaseback vehicle, Juturna. The vehicle was taking the inflation-linked rents from Broadcasting House from the BBC and paying them to Morgan Stanley, in return for fixed cashflows. Juturna then issued fixed-rate notes to commercial mortgage-backed securities noteholders.
The swap was significantly in-the-money to Morgan Stanley, creating an opportunity. “On the one hand, we had a large receivable from Juturna, which is basically the BBC, and on the other hand a large payable directly to the BBC under the new swap we just transacted,” says Lipscomb.
“From the BBC’s perspective, it really needed to risk manage its position toward Morgan Stanley under the new swap, and from our perspective, to be able to release value to them from getting out of the Juturna risk, we needed to be able to net it with the payable under the new swap,” he adds.
Morgan Stanley novated its in-the-money swap with Juturna to the BBC, leaving it to take credit risk essentially to itself. As the BBC was now intermediating between Juturna and Morgan Stanley, this netted down the corporation’s exposure significantly.
The move also released a significant amount of credit and funding valuation adjustment reserve Morgan Stanley had been holding against the Juturna trade, part of which was passed to the BBC as compensation for the net exposures they were taking on from the novation. As a bonus, Standard & Poor’s gave a four-notch credit rating uplift to the Juturna notes, as the new swap counterparty – the BBC – had a better rating than Morgan Stanley.
Alongside this structuring work, the US bank also boasts a full-service flow team, trading cash inflation-linked bonds, cleared and non-cleared swaps and options across the major international and domestic European indexes.
“They’re a strong vanilla shop and they’ve got good market share in cash linkers and swap products,” says a derivatives trader at one asset manager in London.
The asset manager highlights the bank’s prowess in inflation options, saying it quotes competitively and has a good source of supply. Morgan Stanley’s Winkworth says the bank has been involved in a number of large sterling inflation options trades that are “orders of magnitude larger than anything that would trade in the interbank market”, where the largest trade was around £200,000 per basis point of inflation in the last year.