Inflation buyers: using swaps

Use of inflation swaps as a hedging tool has grown as pension funds adopt LDI strategies, finds Nina Röhrbein

Swaps provide a better match for pension liabilities than other solutions, such as bonds, which tend to have a shorter duration than liabilities, according to actuarial consultancy Lane, Clark & Peacock (LCP). This is because they can be written with any duration up to 50 years and more, and thus reduce the exposure to interest and inflation rates.

A swaps contract is an agreement between two parties to swap one set of pre-defined future payments for a different pre-defined set over an agreed period. For an inflation swap, a fixed payment is exchanged for a variable payment linked to a measure of inflation, such as the retail prices index (RPI).

Inflation swaps can be run as an overlay on existing assets. The ideal providers are investment banks with large, sophisticated clients or asset managers with packaged products or inflation management, according to Watson Wyatt.

“What has been driving the inflation swaps market over the past few years is pension fund’s desire to better match their liabilities. They are and increasingly looking at liability-driven investment [LDI] strategies as liabilities more or less have an inherent inflation link,” says Jeroen van Bezooijen, senior vice-president and products manager LDI Europe at fixed income manager Pimco.

“Before inflation swaps entered the market, pension funds were relying on governments to issue inflation-linked bonds to build inflation-linked assets,” notes Vincent de Martel, (pictured right) senior strategist in the strategic solutions group at asset manager Barclays Global Investors (BGI).

“Investors also used to hedge their inflation liabilities through asset classes such as equities and real estate, but the correlation between their return and inflation over the short and long-term has not been that good,” says Guillaume Baijot, inflation trader at Fortis Investments in Belgium. “The advantage that inflation swaps have is that they can be tailor-made and, unlike inflation-linked bonds that have a fixed maturity and a standard payment schedule, investors can determine their own maturity and payment schedule.”

“They enable investors to get access to inflation hedging without having to buy the associated traditional bonds with their credit risk or interest rate exposure,” adds De Martel. “They are also capital efficient, meaning that investors do not need to allocate cash to this strategy and disrupt their underlying assets in order to get exposure to inflation.

“Inflation swaps have moved into the spotlight, as the level of inflation and current inflationary environment is of great concern to investors,” says Kevin Anderson, (pictured left) managing director and global co-head fixed income beta solutions at State Street Global Advisors. “If a pension fund wants to remove uncertainty on a 30-year inflation-linked liability then an inflation-linked swap provides realised inflation and hedging.” 

Some risks

The main disadvantages of inflation swaps are their limited liquidity, especially in longer duration or regional indices, their collateral requirements and that they are still a new area for most investors, says Watson Wyatt.

Swaps also present some risks, mainly in the form of basis, market value, counterparty, legal, liquidity, complexity and operational risk. And a pooled approach - with trustees investing money in one or more swap-based funds with stated objectives - is likely to be more suitable to smaller and mid-size schemes than a segregated approach due to the legal fees and set-up costs according to LCP.

“Experience matters in this over-the-counter market in order to be able to control the pricing of these instruments over time,” says De Martel. “So the ability to price inflation swaps independently is key, as inflation swaps are more complex than conventional bonds or interest rate swaps. The sterling market is still a small market for inflation and so we have seen some pressure in the form of reduced liquidity on inflation-linked bonds in the first quarter of this year. The euro inflation market has so far been able to take the increased volumes without any major disruptions.”

“One of the downsides is that the sterling inflation swap market is less liquid than the sterling interest rate swap market,” agrees Philip Rose, head of ALM at Redington Partners. “Liquidity is concentrated in the longer 20-to-50-year tenors, while short-dated inflation swaps - below 10 years - are relatively illiquid.”

“Liquidity has been picking up on the back of the underlying bond market with increasing tenors, issuers - such as Italy, Greece and Germany joining France and the UK - and maturity dates over the last few years,” says Max Verheijen, (pictured right) managing director at the Dutch investment and risk services adviser Cardano. “And bid-offer spreads have tightened to 3-6 bps.” 

Who’s playing?

De Martel identifies four main players in the inflation swap market: the governments that issue inflation-linked bonds, the corporate world (investors in infrastructure and real estate, for example), pension funds and hedge funds. “As an asset manager we invest in inflation swaps and use investment banks as brokers to trade in pension fund portfolios,” he says. “For corporate entities, it has become more attractive to use inflation swaps rather than issue inflation-linked corporate bonds. Hedge funds either buy or sell inflation and their role is to ensure that the market is arbitraged properly.”

“Hedge funds tend to use inflation derivative markets for more active trading strategies, for example to take advantage of the volatility at the short end of the curve or relative value trades at the long end,” says Van Bezooijen.

According to Rose, the main users of inflation swaps have been UK defined benefit pension schemes that have long-dated inflation-linked liabilities. “The market has increased substantially over the last few years, with volumes doubling each year,” he says. “But demand has slowed somewhat over the last year as inflation levels have risen.”

According to Watson Wyatt the UK inflation-linked market grew to £20bn (€25.1bn) in 2006.

Apart from pension funds, life insurance companies, real estate companies and retail investors have also shown great interest in inflation swaps, says Baijot. “And of course there is interest from asset managers as inflation swaps can help to diversify their portfolios.”  

Pricing swaps

“Transaction costs for inflation swaps are two-to-three times higher than for interest rate swaps,” says De Martel. “Five years ago they would have been even higher, so transaction costs have come down with the increased competition.”

Baijot says inflation swaps are priced according to the level of inflation-linked bonds. “We derive all the prices for structured products from bond and swap curves in the market.”

The three most prevalent structures of inflation-linked swaps are the Standard Interbank inflation-linked swap or zero-coupon inflation-linked swap, with payment exchanged at the end of the term, year-on-year inflation-linked swaps and inflation-linked income swaps, according to Fortis Investments.

But zero coupon inflation-linked swaps appear to be the market standard. De Martel attributes this to investors focussing on pricing transparency and liquidity, in particular in the wake of the credit crunch. “In the inflation market investors have been looking to find the vehicles with the most liquidity and transparency and the lowest possible cost of implementation, meaning that the so-called plain vanilla inflation swaps are the ones most in demand,” he says.

“Any products we trade, which may be more exotic inflation derivatives for pension funds, have the zero coupon swap as the building block,” adds Anderson.

“Year-on-year inflation swaps where payments are exchanged every year are less appropriate for pension funds, as they lack the compounding effect zero coupon swaps have,” says van Bezooijen. “They are more favoured for retail type products.”

“Generally, pension funds will not react to short-term pressures,” says De Martel. “Their primary driver is really to try to optimise the risks and returns in the portfolio because they have to provide future inflation-linked pension increases to pensioners. Around a quarter of the top 100 pension funds in the UK now have inflation swaps in place with us, in other words the swaps have become very mainstream although traded volumes are not made public.”  

Continental interest

According to Anderson, the focus for inflation swaps still lies in the UK market. But Baijot disagrees: “There is a lot of concentration on euro inflation via the euro-zone harmonised index of consumer prices excluding tobacco (HICPxT). Recently, more attention has been paid to domestic inflation, as investors realised that the correlation between their domestic and euro inflation was not that high, despite the sharing of one currency in the euro-zone. And this is why we are now selling more products linked, for example, to German or Spanish inflation.”

“The degree to which pension funds have an inflation linkage differs between the UK and continental Europe,” says Anderson. “In the Dutch pension fund market, for example, the FTK regulations have a conditional rather than an absolute requirement to provide inflation-linked linkage to pension liabilities.”

“In the UK, by law pension funds will have to index their pensions with inflation, which is not the case in other European countries,” notes Van Bezooijen. “In the Netherlands, pension funds have historically tried to compensate their pensioners for inflation but this is not guaranteed and therefore some will not hedge inflation but instead make up for it by trying to achieve high returns.”

“The Dutch government has yet to issue an inflation-linked bond and so there is no supply of Dutch domestic inflation bonds,” explains Verheijen. “But looking at its deficit, it is clear that the Dutch government would never be able to issue enough inflation-linked bonds to hedge the total liability stream of Dutch pension funds. And so although Dutch pension funds have to pay domestic inflation to their pensioners, they hedge with euro inflation. Our analyses have shown that it is better to hedge with euro inflation than not hedge at all - although the hedge ratio does matter - and we have seen a lot of demand for that from Dutch pension funds. With rising inflation and funding levels - as they only pay out inflation when they are at high funding levels - we expect this to continue.

“The problem with hedging domestic inflation using swaps linked to euro inflation emerges whenever both inflation rates do not move in the same direction, in other words when euro inflation drops and domestic inflation rises. This so-called basis risk is less than the inflation risk itself.”

“Although correlations have increased, different European markets have different levels of inflation that often do not move in tandem,” agrees Anderson. “And although the HICPxT provides a reasonable hedge, some market players look for the exact domestic inflation to which they are linked. However, the supply in continental Europe at the longer end of the market - the 25-to-30-year area - is lower than in the UK. The euro inflation swaps concentrate on shorter ends of the curve such as10-year swaps, while pension funds try to find a more exact match with their liabilities and mainly look at 30 to 40 year maturities.” 

Growing demand

One of the biggest challenges for the inflation market is supply pressure. “Demand for inflation swaps in the UK is outstripping supply, which has led to the increase in long-dated break-even swap levels, in other words the price of inflation swaps,” Anderson says. “A year ago a 30-year inflation swap cost around 3.05% of the RPI compared to 3.75% today. This means that the investor has to pay the counterparty 3.75% per year for the next 30 years to receive all the realised RPI inflation over that period.

“The biggest supplier of inflation into the market in the underlying physical bond market is the [UK] Treasury through inflation-linked gilts, but few corporates now supply inflation to the market. Particularly, property-linked streams of finance have dried up over the last six-to-nine months due to financing problems at the short end of the curve, especially in the wake of the credit crunch.”

“Lending has been reduced and so it has become more difficult for the broker-dealers and banks to actually source inflation sellers,” adds Van Bezooijen. “That has hampered the market and to an extent driven up prices.”

However, Baijot counters: “Supply issues have always been a problem in this market, especially in the early days when only one country - France - issued euro inflation-linked bonds. Today it is definitely less of an issue than it was at the beginning.”

“Historically a large amount of inflation exposure was sourced from securitisations of utility or property-backed assets, often guaranteed - also called wrapped - by a monoline insurer for an AAA rating,” says Rose. “But the increase in monoline credit spreads - and their perceived riskiness to both end investors and hedge providers - has meant that this source of supply has almost dried up, so that even with reduced demand inflation swap levels have continued to increase.”