The simple life

Rising inflation, combined with falling or stable interest rates, has left investors with mark-to-market losses on inflation range accruals. Instead, investors are turning to simple products offering protection against further increases in inflation. By Wietske Blees

Inflation range accruals were one of the big structured products stories of last year. Convinced the European Central Bank (ECB) would continue to hold inflation close to its publicly stated target of 2% - a goal it had more or less achieved successfully since its inception - investors flocked to products that paid enhanced coupons so long as European inflation remained within a specified range.

Buyers were helped by growing liquidity in an interbank market for inflation options, allowing dealers to offset long volatility positions they accumulated through selling these structures. At the same time, the emergence of daily, observable pricing points for caps and floors gave banks greater confidence in pricing these products. Dealers estimate upwards of EUR1 billion of range accruals were sold in 2007, with most set with a range of 0-3%.

That looked like a sensible trade for much of last year. The harmonised index of consumer prices (HICP) for the 27 countries of the European Union flitted between 1.8% and 2.2% for the first nine months of 2007 - largely consistent with levels recorded since the 1990s. However, rising food and oil prices have dragged inflation sharply higher in recent months, with the HICP for the EU hitting 3.9% in May, compared with 3.6% in April and 3.8% in March. That means the vast majority of range accruals launched last year would not be paying coupons. And with implied volatility on inflation options surging, investors have been saddled with nasty mark-to-market losses.

Range accruals aren't the only instruments to have suffered. Another structured product, popular at the tail-end of 2005 and throughout 2006, has also been hit. Known as Ice notes, these products paid a coupon linked to Euribor, capped at a multiple of inflation. For instance, one note, issued by BNP Paribas in November 2005, paid Euribor plus 50 basis points, capped at 150% of the annual inflation rate.

The notes were designed to take advantage of the fact that the Euribor curve was much steeper than the HICP curve - the market expected interest rates to rise, but inflation to remain benign. Most Ice investors, however, believed any hike in interest rates would most likely be accompanied by a rise in inflation - so long as this occurred, investors would continue to benefit from an outsized coupon.

These products essentially attempted to generate value from the shape of the inflation and interest rate curves, and by taking a view on volatility and correlation, rather than seeking outright protection against rising inflation.

"In the low and stable inflationary environment of 2006 and 2007, products such as Libor capped at inflation and range accrual notes, where investors were selling volatility, were very popular. Investors were more interested in generating value than in protecting themselves against inflation," says Benoit Chriqui, head of European inflation trading at Barclays Capital in London.

In recent months, however, falling house prices, rising foreclosures and multi-billion-dollar bank writedowns have meant central banks have been reluctant to hike rates, despite strong signs of rising inflation. The ECB, for instance, has kept its key interest rate on hold at 4% since June 2007 - although governor Jean-Claude Trichet has hinted that a future rate increase may be on the cards, perhaps as early as this month. Some central banks have gone further and cut rates: the US Federal Reserve has slashed rates seven times since September 2007, lowering the federal funds rate from 5.25% to 2%.

That is bad news for investors in Ice notes. Some variations were also structured that paid a multiple of inflation capped at Euribor. The fact the ECB hasn't increased interest rates means investors are fast approaching those caps.

"Ice notes and range accruals have not performed very well. As the ECB has not hiked rates, despite the rise in inflation, Ice note caps are now too close for comfort for noteholders, while in many cases inflation has moved out of the range set by range accruals," says Mark Greenwood, an inflation options trader at Royal Bank of Scotland (RBS) in London.

Despite losses on both the Ice notes and range accruals, dealers report steady demand for new structured products linked to inflation - although investors are now looking for protection against further rises in the HICP rate, and are willing to pay extra for inflation options to achieve it.

"Investors typically only look to buy protection against inflation when inflation risk increases and protection becomes more expensive," notes Chriqui. "When inflation is low, inflation structured products, although cheap, are less popular. In the past few months, investor interest in such products, particularly on the shorter end of the curve, has significantly increased."

Exacerbating this trend is the fact that billions of dollars of inflation-linked structured products are set to mature this year. These instruments - overwhelmingly simple inflation-linked notes with 0% floors - were sold in 2003, and have performed strongly in the rising inflationary environment.

"Approximately 80% of the EUR12 billion worth of European medium-term notes issued in 2003 had five-year maturities and are due to expire during the course of this year," notes Dariush Mirfendereski, London-based head of inflation-linked trading at UBS. "Investors holding these notes have received very attractive coupons in the high inflationary environment of the past year and are likely to replace these structures with new inflation-linked notes as they mature."

The big difference between the products sold now and those proffered to investors in 2005, 2006 and 2007 is simplicity - buyers are once again looking to gain exposure to rising inflation through straightforward index-linked notes. "This year, it is the vanilla-type structures offering simple protection against further increases in inflation, such as inflation plus a fixed rate with a 0% floor or leveraged inflation structures, which are in demand. Because of the embedded floors in these structures, investors have become net buyers of volatility. This is one of the reasons why implied volatility has increased," says Chriqui.

Indeed, the cost of 10-year 4% year-on-year caps on the HICP excluding tobacco index has leapt from 25bp on June 11 last year to 148bp on June 11, 2008, according to RBS. Despite rising costs, a variety of structures have emerged that play on the same theme - to enable investors to benefit from high inflation.

For instance, BNP Paribas reports strong interest in five-year notes that pay a fixed coupon in the first year, followed by inflation plus a fixed spread in subsequent years, floored at zero. In recent months, investors have been able to achieve a fixed coupon of 4.75%, followed by inflation plus 2.2%. Ten-year geared notes have also been popular, with inflation multiplied by a leverage factor, floored at zero.

Meanwhile, Deutsche Bank is marketing a product, dubbed the Credibility note, which pays a coupon of 6.25%, dependent on the number of days in a year that inflation remains above a predetermined barrier - currently, 1.8%. "It's a fairly simple structure that has only a downside barrier," explains Daragh McDevitt, head of inflation structuring at Deutsche Bank in London. "Since January 2000, inflation has printed below 1.8% only 11 times out of 101, but if it drops below the barrier the investor will not receive the coupon for that month. Investors are paid at the end of every year."

RBS has also launched a new product, called Strategy against High Inflation and/or Economic Slowdown (Shield), designed to allow investors to gain in a high inflationary environment, but with the additional benefit of a high floored coupon. Launched in April, the 15-year note pays HICP excluding tobacco plus 4%, with a floor of 6%.

"The idea is that we are facing high inflationary pressures, but the ECB has less room to manoeuvre in the light of the credit and liquidity crisis," explains Greenwood. "The Shield structure combines a cap, which offers an attractive payout if inflation is high, with a high fixed-rate coupon, and as such offers protection against both high inflation and a cut in rates."

The transaction - the first inflation-linked lower tier 2 offering by RBS - totalled EUR145 million in notional, and was sold to insurance companies, asset managers, banks and private banks in Europe, Asia and the Middle East.

However, strong demand for inflation protection has contributed to a supply and demand imbalance in the inflation market. With the credit markets still under pressure in the wake of the subprime crisis, few issuers are willing to launch inflation-linked deals, constricting supply. On the other side of the coin, demand for inflation protection from pension funds and others pursuing liability-driven investment strategies has remained strong. According to RBS, the cost of a five-year HICP excluding tobacco inflation swap has increased from 2.25% on June 11 last year to around 2.62% 12 months later.

"Demand has increased not just from the traditional retail and fixed-income investors, but there is also a whole range of equity investors that have been looking for protection. Unless this demand is matched by increasing offerings on the part of inflation issuers, we will see breakevens reach far higher levels," says Mirfendereski.

In the inflation option market, the supply and demand imbalance is even more acute. Dealers report that one-way interest in going long inflation volatility has made it difficult to offset positions in the nascent interdealer inflation options market. At the same time, there is little appetite by banks to warehouse this risk. "There has been a pretty extreme movement in the volatility market, as many investors have quite suddenly moved into inflation protection strategies, while there is not yet enough capability in the market as a whole to warehouse this risk," notes David Slater, head of UK inflation trading at BNP Paribas in London. "This has caused some desperate bidding to occur in the interdealer market and has ultimately served to drive option prices up further."

In fact, prices on inflation options have risen so much, some dealers suggest investors may begin to switch out of the market in favour of interest rate structures. "It is extremely costly to manage the gamma on year-on-year inflation options with a five-year maturity, because such structures are typically hedged through one-year forwards, and the short-dated inflation market is extremely illiquid," says Stephane Salas, head of inflation trading at Societe Generale Corporate and Investment Banking in Paris. "The cost of five-year inflation year-on-year volatility hedges is 120% of the cost of interest rate volatility hedges. If that cost goes up to 150% of nominal volatility, I would expect investors to turn to interest rate protection as a means of hedging themselves against inflation."

There are, however, signs that some investors are taking advantage of high implied volatilities to go short, either directly as part of a relative value strategy or through new range accruals and Ice notes. "Current inflation volatility is quite rich compared with nominal and historical volatility, providing interesting opportunities for relative value plays - for example, by selling volatility outright or by selling current volatility versus nominal volatility," explains Chriqui. "One typical trade would be to sell 10-year 0% inflation floors, buy 10-year 2% Euribor floors, and receive an upfront premium. If inflation stays positive, you make the premium; if inflation starts to go negative, the ECB will probably aggressively lower rates, and you will make more money on your nominal floor than you will lose on your inflation floor."

Meanwhile, investors putting on range accruals would now be able to achieve significantly higher coupons than would have been possible 12 months ago. For example, the coupon for a 10-year product issued last year, funding at Euribor flat, would have paid six-month Euribor plus 2.55%, so long as inflation stayed between a range of 1.5% and 3% over the observation period. Today, that same product would pay six-month Euribor plus 4.25%.

"We're still seeing some interest in range accruals," notes Slater of BNP Paribas. "As inflation volatility has increased to such high levels, the pick-up that investors can get for betting inflation will stay within a range has also increased a lot."

"Aside from the usual structural demand for inflation protection, we're seeing more speculative demand from investors who don't necessarily have existing liabilities, but who feel inflation as an asset class can deliver strong returns and that there is good value in selling volatility," agrees Sebastien Goldenberg, head of European inflation products at Citi in London. "As a result, we are not just witnessing demand for structures that are long volatility, but there is also continuing demand for structures that are short volatility, such as callable bonds and range accruals."

There are also opportunities for those willing to maintain existing Ice note trades. "While the mark-to-market value of Euribor capped at inflation products has been adversely affected by increased volatility, as a result of the high inflation fixings inherent in most of these structures, the option is still out of the money, and investors can be paid the margin at every coupon date, making for an attractive carry trade," adds Slater.

It may not be the easiest time for inflation traders, with the supply and demand imbalance making it increasingly costly to obtain protection against rising inflation. However, dealers expect interest in inflation-linked structured products to continue so long as oil and food prices continue to climb. "Investors are currently re-evaluating their views on inflation, as well as the role central banks can play in mediating these issues," says UBS's Mirfendereski. "The current spike in inflation may well trigger a complete regime change, and if that is the case, inflation products will most certainly become one of the hottest products around."