After the first inflation swap repack was executed in 2012 – cleaning up potentially toxic legacy trades by splitting them into bonds and new, simpler swaps – it triggered a structuring arms race, as dealers sought to make the trick more accessible and easier to pull off.
The 2015 Yorkshire Water deal included swap restructuring at the outset. In 2016, the Thames Water structure sidestepped the requirement for the utility to go through painful documentation changes that are needed in order to face an unrated special-purpose vehicle (SPV) – a key part of the traditional structure.
This year, HSBC went one step further, devising an approach for Yorkshire Water’s latest deal that did away with the SPV altogether, instead making itself the intermediary between the utility and end-investors. This makes the deals easier to pull off for corporates that are unable to face SPVs, while also allowing end-investors to receive super-senior inflation-linked cashflows – and it was done without the investors taking HSBC credit risk.
“This is part of the reason why we could offer such an attractive price alongside such a neat way of achieving what’s been done many times before by different banks, but in slightly more problematic ways,” says William Higbee, a director in the corporate risk solutions team at HSBC.
Inflation swaps linked to the retail price index (RPI) were a popular way for UK utilities to fix their RPI-linked revenues before 2008. These trades – almost always uncollateralised in order to protect the utility’s credit rating – 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 and raising the likelihood that the bank would use its option to break the transaction at one of a number of fixed points during the deal.
In theory, a repack benefits both sides. The cashflows are novated to the SPV, which routes them – and the counterparty risk – to real-money investors via RPI-paying notes. The swaps are then easier to restructure and novate, or to leave in place.
In early 2018, Yorkshire Water put out a request for proposal to a number of dealers to tackle some issues with its existing swap portfolio of bond-style inflation swaps, in which it paid a real-rate coupon and a large cumulative inflation payment at maturity, and received Libor-linked cashflows in return. The company had two primary goals: to alleviate pressure on interest rate coverage ratios, and to deal with a series of mandatory breaks in early 2020.
HSBC pitched a restructure and repack solution and, after extensive discussions with the company and its hedging adviser, Rothschild, won the deal. Yorkshire Water gave HSBC four weeks to conclude the transaction.
To start, the UK bank had to novate in 25 individual swaps with maturities from 2029 to 2063, with a notional value of £374 million ($480 million), from five other dealers. It then extended the mandatory breaks embedded in £117 million notional of swaps by ten-and-a-half years, and harmonised the fixed real rate payable across all the swaps – previously, each swap had a different rate despite some having the same maturity.
The next task was to remove a feature known as pay-as-you-go from one swap, in which the balloon payment at the maturity of the contract is spread across the life of the trade. It then novated back 20% of the now-restructured swaps to two other banks, to reduce Yorkshire Water’s counterparty concentration to HSBC.
The bank then took these remaining swaps, plus some existing swaps the bank previously held with Yorkshire Water, and bifurcated them to produce interest rate and inflation cashflows as per a normal repack.
Ordinarily, the inflation-linked cashflows would be sent to an SPV at this point, which would issue notes to the end investors. This can be an obstacle for some corporates because it requires the amendment of inter-creditor documentation to allow the company to face an unrated entity. Setting up and maintaining an SPV also adds to the costs of the transaction.
“There are a large number of problems with the existing methods. What we wanted to do, given the quantum of business we wanted to be involved in, was to enhance our distribution capabilities by coming up with a knockout way of doing it,” says Shahrear Haque, head of corporate risk solutions for Europe, the Middle East and Africa at HSBC.
In HSBC’s structure, Yorkshire Water faces the bank directly, channelling the swap cashflows through the UK bank instead of an SPV and removing the need for a documentation amendment. On the investor side, HSBC issued a £330 million note to two insurance company investors, through which the cashflows are paid.
The obvious question is what happens to the cashflows between the time the utility sends it to HSBC and it’s passed to investors via the note – an SPV would normally provide comfort that the flows are legally separate if the UK bank was to default. HSBC declines to go into detail about the exact mechanics on the record, citing competition reasons. But broadly, it has developed a technique to achieve the same outcome, legally separating the flows so they are safe in a default scenario.
Another benefit is that the notes have a super-senior ranking in HSBC’s debt waterfall, matching the ranking of the inflation swaps themselves. Class-A debt, which is the normal rank for SPV notes, sits one notch lower. This allowed the notes to be issued at much tighter spreads than usual.
“It really was a watershed moment. And we’re seeing demand to really leverage the technology and use it to do bifurcations on other products as well,” says Haque. He adds the bank has since used the approach in other transactions.
David Gregg, interim head of tax and treasury at Yorkshire Water, was impressed with the result.
“We went out to a number of banks with this request, and HSBC stood out with its approach. When I looked at it, I remember thinking, ‘Is it this simple? Where is the catch?’” says Gregg. “Often you have all these great idea conversations with banks but when it comes to execution it can easily fall apart, but with HSBC they really delivered.”
One of the driving forces behind the bank’s push to expand its credit risk distribution channels is to free up credit lines to do new transactions, especially for trades linked to the consumer price index (CPI) measure of inflation.
On the demand side, CPI hedges are increasingly popular with insurers in particular, who can use them as a hedge for pension liabilities they have been buying, and for their Solvency II capital requirements.
We’re here to be market-makers, to manage supply and demand flows, often when they don’t coincideDariush Mirfendereski, HSBC
The supply side has always been the problem, making life difficult for market-makers, which have to use proxy hedges – for example, RPI swaps, or partially offsetting CPI transactions – and sit on the residual risk, potentially for months at a time. Some dealers are only willing to satisfy client demand for CPI if they have offsetting and immediately available supply, but HSBC has been willing to warehouse risk for its clients this year.
For instance, in January the bank took on a short CPI position via a range of swaps with maturities of 15, 16 and 17 years with a total of £500,000 IE01. IE01 is the sensitivity to a one-basis-point move in inflation. It was already short £200,000 IE01 from a previous trade, putting its total short exposure at £700,000 per basis point.
It chipped away at the position through the year, selling some smaller positions to clients and offloading some risk in the interdealer broker market. But it wasn’t until November that a regulated utility took it out of the position fully with a 28-year, £1 million IE01 trade.
“Are we happy to offer CPI when buyers demand it knowing that actually in the future there ought to be flow on the supply side? Yes, that’s what we’re in business for. We’re here to be market-makers, to manage supply and demand flows, often when they don’t coincide,” says Dariush Mirfendereski, global head of inflation trading at HSBC.
Clients appreciate these efforts: “They have the best ability on the Street to warehouse risk. Some are more opportunistic – they say ‘I have this risk, take it or leave it’. HSBC has a bit more going on, they seem to see more variety of flows,” says an investment manager at one UK insurer.
On the right road
HSBC also landed a role in a rare restructuring of a large CPI swap in Canada. The revenue-style swaps, totalling C$50 million ($38 million) notional per year, were put on by sponsor ACS Infrastructure Development to hedge a toll road project prior to 2008. The swaps were between the project and a number of Spanish banks, with a Canadian bank providing the market hedge for the swaps.
When the deal was refinanced this year, the Spanish banks wanted to trigger clauses that would allow them to get out of the swaps. However, the swap was needed to give comfort to the new bondholders and rating agencies. The company told the banks pitching for the refinancing that they’d also have to come up with a solution for the CPI swap as well – a tough ask in a market that trades very infrequently.
After conducting due diligence, HSBC agreed to take over a portion of the Spanish banks’ positions, with the Canadian bank remaining as the market hedge. But given the project was uncollateralised and the Canadian bank was collateralised, HSBC had to get comfortable with managing the credit and funding valuation adjustment risks.
“HSBC’s work was key not only for the CPI swap but the full transaction,” says Leonardo Paez, vice-president of financial planning and analysis for ACS Infrastructure Development. “If it wasn’t for them, we wouldn’t have been able to novate the swaps. Then the bondholders wouldn’t feel secure in the revenues and we wouldn’t get the rating we were targeting, so the whole transaction falls down.”
As well as carefully managing its capacity to execute big, bespoke transactions, HSBC has had to keep an eye on a risk that would be easy to overlook at the vanilla end of the inflation derivatives market – the emergence of a price difference between cleared and non-cleared trades.
As there is no regulatory requirement to clear inflation swaps, market participants can choose whether or not to use the market’s sole current clearing service, offered by LCH. This produces a basis between bilateral and cleared trades because, broadly speaking, corporates pay inflation bilaterally – opting not to clear, because they are not set up to post or receive margin – while many insurers and pension funds receive inflation via LCH. As these positions can’t be netted, they produce initial margin requirements at both ends, creating extra costs. The basis quoted in the broker market for a zero-coupon RPI swap has risen from –2.1 on December 29, 2017 to –4.1 on October 15 at the 30-year point – implying the fixed rate on bilateral trades are lower. But quotes on the exact mark vary, creating clashes over valuations.
Mirfendereski says HSBC began watching these risks soon after clearing of RPI swaps began, and has run a broadly balanced book for the past two years – not an easy task given the bank’s large corporate client base, where bilateral flows hedged with the market would result in banks paying RPI in the clearing house.
One way HSBC avoids an unbalanced portfolio is by applying the full basis in pricing – making new bilateral inflation-receiving trades cheaper and bilateral payers more expensive, for instance. The bank is also an active user of the broker market to arrange flattening trades, where it has done package trades in clips as large as £200,000 IE01.