In particular, the European Investment Bank (EIB), one of the largest private issuers of inflation-linked bonds in the UK, with around £800 million of outstanding debt at the end of 2003, says it has been quoted bid-offer spreads as high as 30 basis points when attempting to swap its inflation-linked issuance into conventional rates.
“The UK swap market is not very transparent,” says David Clark, head of funding at the EIB. “It’s a classic two-player market.”
Until recently, the UK inflation swaps market was dominated by Barclays Capital and RBS, says Clark. But other institutions, such as Deutsche Bank and UBS, have also entered the fray and are pricing very aggressively – something that has not been taken to well by the market hierarchy, according to market participants.
The major banks say wide bid/offer spreads have been dictated by the lack of a two-way market. With dealers unable to offset inflation risk assumed in carrying out the swap trade as easily as in other markets, investors must pay a premium for the risk.
While demand for inflation has grown in the market during the past few years as investors – primarily pension funds and life insurance companies – have looked to hedge their inflation-linked liabilities with inflation-linked assets, the market has suffered from a chronic lack of supply. Trades tend to be large – regularly in excess of £250 million – and on an infrequent basis, which causes lumpy flows.
“In the UK you can get rapid and violent changes in the swap breakeven levels if any flow information reaches the market,” says Joe Mulvey, senior trader in European inflation derivatives at Barclays Capital in London. “This is a market where you don’t want to show hints as to the direction of flow,” he adds.
This is a self-reinforcing problem, says Mulvey – liquidity is poor because there are not enough participants in the market and market participants are discouraged from getting involved because of the poor liquidity. “Users are discouraged from getting involved so dealers are less transparent than they would be in Europe,” he adds. “Everyone involved has an incentive to keep a degree of secrecy.”
Mulvey says the bank currently transacts only a couple of inflation swap trades per week, but these are often large, certainly relative to euro inflation swap trades. He says bid/offer spreads are, on average, in the 4bp to 5bp range.
Deutsche Bank recently hired Chris Thomas from UBS, one of the biggest cash traders in the inflation-linked market, and has increased its efforts to break into the UK inflation swap business. Rich Herman, managing director and head of European rates trading at Deutsche in London, says the bank trades about 50 European inflation derivatives transactions a month and between 10 to 15 trades in the UK.
Herman says the market has become more expensive recently: “Breakeven rates are extremely high, so customers are paying a lot for inflation protection.”
But, he adds, the long-term situation is encouraging. “I have been surprised at the speed of improvement as end-users have become more involved.” Herman says the standard bid/offer spread in the swaps market are 4bp to 5bp, but this can be much narrower when a dealer has a large ‘axe’.
The EIB’s Clark welcomes the newer entrants in the market but has reservations. “The question of market growth is down to whether new participants enter the market to increase competitiveness,” he says. “The banks like to do swaps with investors.”
The market’s liquidity largely depends on a steady stream of inflation-linked issuance allowing dealers to hedge their books. The major source of sterling inflation-linked bond issuance is the government, but it does not engage in inflation swapping, which, it says, is at odds with its public role. Institutions such as the EIB – the next largest suppliers of inflation – say the pricing imbalance for investors and issuers such as itself has made it more difficult to issue inflation-linked bonds consequently hedged using swaps.