Sharp divergences of opinion on the trajectory of interest rates in 2011 make life difficult enough for borrowers and investors, but regulation is providing an extra layer of ambiguity.
Every year or two, the macro structuring team at Royal Bank of Scotland (RBS) briefs clients on the expected themes over the medium term. In 2007, recession was on the cards. In 2009, it was clear that recession could prove persistent after the severe financial dislocation.
But for 2011, says Huy Nguyen Trieu, head of macro structuring at RBS, the theme is one of uncertainty. Commodity prices and gross domestic product (GDP) growth are both picking up. Yet core inflation is still low, and the sovereign debt crises of 2010 served as a warning that external or financial market shocks could still derail the recovery.
"In January 2010, there was talk of central bank exit strategies, the end of stimulus to avoid a spike in inflation. By July, people were worrying about deflation again, and now the inflation risk is back on the agenda. So views have changed several times in just one year, but most of our clients have investment or financing horizons of five or 10 years," says Mr Nguyen Trieu.
Hedging their bets
For insurance and pension fund clients, the combination of low nominal yields and rising inflation has made it increasingly difficult to generate real returns to meet inflation-adjusted liabilities – without taking unwanted amounts of equity market risk. Chris Murphy, global head of rates derivatives and swaps trading at UBS, says pension fund clients are taking an increasingly sophisticated and hybrid approach to protecting against market developments that could undermine their solvency ratios.
"We have seen a variety of people looking to put on hedges against both falling long-end yields and rising inflation – a combination of inflation swaps and receiving long-term rates," says Mr Murphy.
UBS also works with retail and commercial banks whose net interest margin has been compressed by very low nominal interest rates. Mr Murphy says his team have structured constant maturity swap spreads designed to benefit bank clients if the yield curve flattens. The swap pays out to the clients if the spread between long-term and short-term rates narrows, effectively protecting their net interest margin in the event that rates stay lower for longer.
The uncertainty also leaves corporate borrowers with a serious dilemma. If interest rates are likely to head higher, then it makes sense to buy interest rate swaps to lock in long-term rates that are at historic lows – about 2.8% for five-year sterling swaps. But the London Interbank Offered Rate (Libor) is much lower, at less than 1%, so a floating-rate borrower who hedged with swaps would be paying a very high price in negative carry.
The logical response for borrowers would be to use options markets to avoid locking in long-term rates at a time when it would still be cheaper to maintain floating rate exposure. Interest rate caps allow borrowers to protect against a rate hike for a fixed fee, rather than paying negative carry for an unknown period of time. But options are expensive at present, partly because of market volatility.
"Volatility tends to be higher in lower interest rate environments. If you had put a cap in place two years ago, it would have served you well, because Libor rates have not increased as forecast at that time," says Bill Bartram, a director at JC Rathbone Associates, a specialist boutique that advises real estate, private equity and private finance initiative (PFI) borrowers on hedging strategies.
Shallow market
The market is also still shallower than before the crisis, making it more difficult to obtain good pricing on bespoke or exotic trades in particular. One swaps trader says banks have retained relatively tight exposure limits on their derivatives desks, and he feels deferred bonuses are already beginning to make traders think twice before agreeing to large illiquid derivative trades that could be difficult to unwind. And the hedge fund sector, which was previously a reliable source of demand for more esoteric risks that banks needed to lay off for their clients, is still some way from its pre-crisis appetite.
"On the short-dated trades, plenty of hedge funds are still interested, but they are much less active, specifically on the long-dated products that are less liquid," says Elie El Hayek, global head of rates at HSBC.
Elie El Hayek, global head of rates, HSBC
Some corporates may simply choose to stay with unhedged floating rate exposure, while pension and insurance funds could increase equity allocations to offset low real rates. But this is not prudent risk management at a time of such market uncertainty, and Mr Bartram adds that most property or private equity borrowers may have mandatory hedging requirements written into their funding covenants.
One alternative is to use forward-start or window swaps that offer flexibility about when to lock in the fixed rate. If the yield curve moves lower in the meantime, then the fixed rate will be lower as well. This is also useful for borrowers wanting to pre-hedge their financing, leaving them free to take an opportunistic approach to funding given that credit markets are also volatile.
Mr Nguyen Trieu says the uncertainty and lower liquidity in rates and inflation markets can also create opportunities for tactical entry points, rather than trying to meet all hedging requirements immediately.
When fears over deflation returned in July 2010, eurozone inflation swaps fell much more sharply than swaps on the Euro Interbank Offered Rate (Euribor), even though rates and inflation would normally be expected to move in tandem. Consequently, for a pension or insurance fund that needed to protect against deflation, buying a floor option on Euribor was much cheaper than buying inflation floors.
Regulatory changes for pension or insurance funds can also create forced buyers or sellers of rates and inflation exposures, producing temporary market anomalies. Mr Nguyen Trieu says that interest rate markets have seen developments of this sort over the past year due to heavy hedging by Dutch pension funds. And the Spanish forward inflation curve is currently implying heavy deflation, in a country where consumer price inflation is currently 3% and has been negative only once since national records began in 1961.
"Clients want much less complex pay-offs today, but the execution has become more complex. A lot of transactions using caps, floors or swaptions that would have been seen as quite plain vanilla a few years ago now involve a lot more work to deliver," says Mr Nguyen Trieu.
Regulatory change
The other factor driving the business is changes in regulation right across the financial sector. Kara Lemont, European head of interest rate and foreign exchange structuring at BNP Paribas, says much of her team's work in 2010 was linked to clients' regulatory needs rather than market views. These needs included the advent of Solvency 2 for insurance companies, changes in accounting rules, and growing attention to counterparty risks, for example in the draft Basel III bank capital regulations.
"Insurers want to enhance duration to match their liabilities better under Solvency 2, but without selling down their existing cash bond portfolio. On the rates side, much of the work we have done has involved wrapping techniques more often seen in the credit or repo space, so we have worked more closely with the credit structuring teams. Often the client wants a relatively simple rates product, but with a specific wrapper to meet counterparty risk or accounting issues," she says.
For banks themselves, the US Dodd-Frank Act and the European Market Infrastructure Regulations (EMIR) are both pushing in the direction of centralised clearing for swaps and derivatives. In theory, this should be less significant for interest rate derivatives than, for example, credit derivatives, because the rates market was already mostly centrally cleared. According to Ms Lemont, "about 80% of our business is electronic, as voice-trading is not always cost-effective for commoditised product. The other 20% is exotic trades that will not be eligible for central clearing in any case."
Cause for concern
But there are still points of concern both for banks and their clients. Chris Murphy of UBS feels the Dodd-Frank proposal that banks should trade standardised derivatives through a third-party "swap execution facility" could disintermediate the clients from banks that are not just structuring, but also acting as relationship liquidity providers for many trades.
On the client side, the European property sector is expressing particular alarm. While corporates look certain to be exempt from the requirement to clear derivatives centrally, real estate companies, especially funds, do not appear to benefit from the same exemption under the EMIR regulations. Instead, they may be classified as financial counterparties alongside other alternative investment vehicles. Mr Bartram says the industry is lobbying hard to ensure that implementation of EMIR takes account of the specific nature of the real estate industry, where all lending (including swaps liquidity) is secured in any case.
"Since a clearing house would not recognise real estate collateral, property companies would have to hold cash on the balance sheet earning less than 1%. The mark-to-market value of swaps transactions can be up to 20% of total loan values, so this much cash would destroy their internal rate of return," says Mr Bartram.
If the corporate exemption is not extended to the property sector, the alternatives would be options-based hedging with an upfront fee to the bank rather than a collateral requirement, or fixed-rate borrowing. The return of real estate securitisation could also prove helpful, because interest rate hedging can be included in the special purpose vehicle (SPV) constructed for the transaction, rather than sitting on the property company's own balance sheet.
With so much uncertainty in the air, the banks themselves are keeping an open mind about where the best opportunities will lie in 2011. Ms Lemont says her bank's interest rate derivatives work is now relatively balanced between institutional investors, borrowers and structured products, by contrast with previous years where one client group or product tended to dominate.
"There is not one area that dominates, partly due to client demand, but partly also because we have made an effort to broaden out our business mix given the market volatility and the new regulatory environment and constraints," she says.
While many interest rate structured products did not cope well with the 'long-tail' event of Libor contracting from about 6% before the crisis to less than 1% in a matter of months, leading providers to the wealth management industry say demand is picking up again, not least because real yields are so low. Mr Murphy says products at the moment are typically structured to take advantage of the relatively steep yield curve.
"We are structuring simple callable or daily range accrual products that allow investors to earn a return by selling optionality, and by investing further out on the curve," he says.
Algorithmic indices
And Ms Lemont is confident that algorithmic interest rate indices will continue to gain market share from funds of hedge funds that lost the confidence of investors by gating withdrawals at the height of the crisis. By contrast, investable indices provide greater transparency on investment strategies and daily liquidity. Algorithms can also be used as hedges for corporate treasurers who fear rising rates but do not know exactly when those hikes will take place.
Of course, the other clear source of yield enhancement right now is emerging markets, where growth is strong and interest rates are already rising. Here, the challenge for structuring banks is to provide investors with access to interest rate markets that are much less liquid, and may be subject to government measures to curb heavy speculative inflows.
"The situation is becoming more complicated as some emerging markets introduced new taxes and regulations, so things have slowed a bit and emerging market rates will become a more complex product. But liquidity is improving, and at a certain time, perhaps a decade from now, these markets will be as liquid as developed markets, there should not be anything that can stop this trend," says Mr El Hayek at HSBC.
