Banks find ways to play the price as inflation rises

Dariush Mirfendereski, head of inflation-linked trading at UBS investment bank, has left his screen with some trepidation. Market conditions are wild, in every sense. He has just watched market-implied rates of inflation for the UK hit new highs for the year – and indeed for the entire period since the Bank of England became independent in 1997.

“In the past three or four months we’ve been busier than ever, in terms of enquiries and trades,” he says.

And as inflation risk increasingly finds its way out of esoteric financial modelling and on to the front pages of the mainstream press, demand for inflation-linked products is spreading beyond traditional buyers.

“Equity investors are concerned about price/earning ratios dropping in high-inflation environments, whether it is the UK, the US or the eurozone. Therefore many of those accounts who previously looked at interest-rate hedging are actually looking at inflation,” says Mr Mirfendereski.

At Barclays Capital, global inflation-linked product manager Ralph Segreti notes that popular discussion of the subject has also encouraged the retail and high-net-worth clients to move in, prompted by the impact of higher prices on their own wallets.

“When US gasoline prices reach another milestone, we see a big pick-up, in Asia it has been rice prices. But we are seeing a large incr­­­ease in interest globally from the private bank world,” he says.

Here to stay

Basic retail products include inflation-plus notes in the US and so-called ­inflation multiplier products in Europe, both of which offer guaranteed returns over inflation. Meanwhile, says Mr ­Segreti, Asian investors are responding by increasing general investment in fast-growing emerging markets.

Retail investors are sometimes characterised as dumb money getting in at the top of the market. After all, the world’s leading central banks have spent time and effort establishing their inflation-fighting credentials, and will surely offer a suitably tough response (see below). But on this occasion, sophisticated institutional investors are in agreement that they must consider the possibility of a sustained upward trend.

They include Mark Farrington, head of currency management at Principal Global Investors. He warns that companies and investors may have been lulled into a false sense of security by non-cyclical factors that have created more than a decade of low inflation.

These factors were technological innovation – especially in IT and communications – and globalisation, which raised productivity and profitability worldwide and integrated cheaper labour pools into the global economy.

“You had this one structural windfall that passed through, but once you’ve done that, it’s over,” Mr Farrington explains. “You don’t have any more Chinas or Indias. You’ve drawn the educated, mobile workforces of those countries and you’re down to the area where you’re taking more people from the countryside; some have been banned from living in the cities or they can’t really afford to live there.”

Moreover, while the economy previously enjoyed the tailwinds of technology and globalisation, it seems set to face headwinds in the coming decade. These include historic underinvestment in food and oil production that is now generating supply shocks, together with rising constraints from environmental damage that further drives up costs.

The growing consensus on what Mr Segreti calls an “inflection point” in global inflation dynamics has been reflected in expectations surveys, with the University of Michigan survey in the US reporting a consensus one-year inflation forecast for May 2008 of 5.2%, the highest reading since 1982.

Elusive real returns

The markets are pricing in this alarm, amid high volatility. In the UK, many believed break-even inflation – the difference between yields on indexed-linked and unindexed nominal government bonds – had become expensive when it crossed 3% in 2007. The level is now breaching 4% across much of the yield curve (actual year-on-year inflation was at 3.3% in May 2008), and it is starting to hurt some of the largest investors of all.

Although many corporate pension funds have closed their defined benefit schemes to new employees, the bulk of existing pension liabilities are still indexed to the cost of living, and insurers also make payouts that rise with prices.

Investment and risk management consultant Redington Partners estimates that under UK accounting rules, every basis point rise in break-even inflation adds about £820m ($1.6bn) to the aggregate pension liabilities of the FTSE 100 companies. Robert Gardner, a founding partner of Redington and former Merrill Lynch banker, says conventional value-at-risk accounting prompted many schemes to believe that they were more sensitive to interest rate volatility than inflation risk – a view which they are now hastily revising.

BAM offers a number of multi-asset-tar­geted return strategies, including the Extended Risk Fund that explicitly aims to deliver consumer price inflation plus 5%.

In the current climate, this is a tall order. Mr Cole notes that during the previous inflation shock in the 1970s, equity markets as a whole underperformed, except for those stocks that retained pricing power such as resources companies. But large funds would not be willing to concentrate exposure too heavily in a handful of sectors.

Another sector that promised solid real returns in the 1970s was property, both commercial and residential. But the context is very different this time around, with recent bull or bubble markets in the US, UK and Spain all now in retreat amid the freeze-up in mortgage securitisation.

“It is not cheap on a yield basis, residential rents relative to incomes or any of those valuation measures, or more importantly the level of debt required to finance property, as so much excess liquidity from debt creation has gone into property,” says Mr Cole. “So for the moment, I’m not sure real estate is cheap enough to defend you against higher inflation rates, particularly as we go into an economic slowdown. I’m not sure that rents are tight enough to hold if vacancy rates go up.”

David Slater, head of structured inflation trading at BNP Paribas (BNPP) in London, also warns that real estate developers and managers may struggle to originate new sources of index-linked rents.

“My worry is that the publicity regarding the rate of inflation and oil prices will maybe reduce the general tenant enthusiasm for putting inflation in the contract,” he notes.

Mr Segreti at BarCap agrees that the property market may have further to fall, but adds that when it does turn, yields on property derivatives could provide value relative to investments in physical property, as well as offering a more liquid and cost-effective way of accessing real estate exposure. BarCap now trades property derivatives through its inflation products desk.

Cheap at any price

Mr Segreti’s observation represents a general consensus that investors would do better to access inflation directly through index-linked and derivatives markets, instead of cash proxies such as equities or commodities.

“The proxy concept is perhaps concentrated on to the detriment of actually trading the [consumer price] index,” says Adam Baker, head of inflation structuring at JP Morgan in London.

“In the same way, you could probably have a good stab at proxying the FTSE 100 or the Dow Jones indirectly by taking, say, 10% oil, 20% gold and short-term rates, but of course you wouldn’t do that, you’d just trade the index.”

Moreover, says Mr Gardner at Redington Partners, proxy exposure is little use to pension funds in countries that have adopted mark-to-market accounting procedures such as FRS17 in the UK. To improve their asset-liability profile, the funds must directly hedge out some of the inflation risk on their portfolios. This means matching the break-even inflation rate that is used for future liability discounting purposes – one of the forms of so-called ‘liability-driven investment’ (LDI) that funds have adopted. These regulatory requirements are driving the appetite for inflation-linked bonds, pushing break-even rates still higher on a technical rather than a fundamental basis.

All this leaves inflation-protected investments looking very expensive – the real yield of the UK’s 2055 government gilt is at a record low of less than 0.3%, which is hardly paying investors for the non-inflation risks. It is also, Mr ­Gardner points out, an insufficient rate of return to offer much help to pension funds that are already in deficit. But he warns that funds should not confuse strategy and tactics. If an investor is vulnerable to inflation on the liability side, they must hedge for strategic reasons, whatever the price.

The rest – how much of the portfolio to hedge at any given time, and how to build that hedge – is tactics. At present, the UK inflation swap curve peaks at the 30-year section, with yields inverted for 50- and 60-year sections, after banks retained the inflation risk in this segment when they sold on loans to utilities in the past two years.

“For pension schemes, there is a discount to be picked up by moving out from 30 years to 50 or 60 years, rather than just matching their exposures exactly,” says Mr Gardner. “You don’t necessarily need to hedge all your risk buckets at the same time.”

Mr Slater at BNPP has seen greater demand for options that can be exercised if the inflation environment continues to worsen. “People are saying, if we don’t want to lock in at these levels, can we buy an option to enter into an inflation swap 50 basis points above here, giving them out-of-the-money protection,” he says.

Shrewd hedging tactics have become even more essential because the supply of traditional inflation products to the market has become uncertain. Mr Baker at JPMorgan notes that the development of full inflation-linked curves in the eurozone has broadened the range of indexed government bonds available, but non-government sources are drying up.

Unpredictable supply

Utilities and infrastructure projects that have explicit indexation in their government-regulated prices tend to issue inflation-linked bonds directly, or to ‘asset-swap’ investors who keep the credit risk and swap the inflation component for Libor rates with other institutions. However, where the inflation swaps derived from such credit transactions, the issuers previously relied on monoline insurance wrapping to generate top ratings and minimise the risks for their counterparties. With several leading monolines now losing their AAA ratings, this mechanism has broken down.

In the UK, Network Rail continues to come to market, thanks to a government guarantee removing the problem of corporate credit risk, while the Pennsylvania toll road project could kick-start a new source of supply in the US.

Mr Gardner adds that plans for an expansion of the London orbital motor­way and a Royal Air Force refuelling tanker project in the UK could both provide new inflation-linked issues as well.

In any case, with demand for inflation products so high, and many companies holding indexed revenue streams, corporate treasurers and bankers alike have a strong incentive to revitalise the inflation-linked market for non-sovereign issuers. Given that real yields are at record lows, Mr Mirfendereski at UBS believes it is still worth considering an unwrapped issue.

“That has not happened yet, because issuers often have targets for the nominal spread to gilts that they don’t want to exceed. But my view is that they should measure what all-in rate they can get compared with, say, three months or so ago,” he says.

“If they are not projecting that inflation is going to stay at 3.9% or more for five or 10 years, if they can lock that rate in then clearly it is worth doing.”

While issuers mull over this dilemma, the banks are already looking for ways to circumvent the concerns over credit risk among the buyers of inflation products. Mr Gardner says pension funds will need to work with their advisors and the banks to enter into direct arrangements with potential issuers on a “soft order” basis that leaves all parties free to take up a better deal if it comes along.

There are also a growing number of structured solutions available. Inflation swaps traditionally trade rich to index-linked bonds because the swaps enable investors to buy inflation protection with a smaller commitment of capital.

The lost monoline insurance on inflation-linked bonds has made swap richness more complex to value. To do this, investors and asset strippers need to be able to accurately measure the credit risk on indexed bond cash flows, which is different to that on a nominal bond because the size of the principal repayment (and therefore the loss given default) increases in line with inflation.

To meet this need, JPMorgan uses structures called accreting asset swaps, where the leg of the trade that pays Libor accretes with inflation.

“By accreting the Libor leg at inflation, we remove the mismatch with the inflation leg of the swap and we accurately value what the credit component should be, giving us a fairly good proxy of what the inflation swap richness should be,” says Mr Baker.

Taking a global view

As well as synthetic products, investors are looking to buy inflation in emerging markets that can boost their real returns – real yields in Turkey are almost 11%. These countries are also more likely to suffer higher rates of infla­tion, because food and fuel form a larger proportion of the consumer price index basket, and structural reform is less advanced, creating economic bottlenecks.

The investment process is not without difficulties. Beyond the most sophisticated financial markets such as those in Brazil and South Africa, inflation-linked yield curves are incomplete and thinly traded. Local institutional investors such as insurance companies in Korea and pension funds in Poland and Turkey are helping to deepen liquidity, but foreign players are often required to settle onshore in each market, driving up operational costs. To overcome these obstacles to access, BarCap established the first emerging market inflation-linked bond index in 2007, with individual country sub-indices.

This has enabled institutional investors who had made tactical allocations to the asset class to take more strategic positions, and asset managers are already considering launching products benchmarked to the index.

“Having an index makes these markets materially easier to access, either through third-party tracker products or directly with us through total return swaps,” says Mr Hawkins. “As you get more inflows with trackers or funds benchmarked to the index, that will also create more liquidity that draws other people into the underlying markets, which then encourages the issuing institutions to say this is a viable market.”

Indeed, adds Mr Segreti, BarCap is moving to meet increased demand for synthetic inflation-based products in countries where there is no inflation market at present, especially China, Russia and south-east Asia. At the other end of the emerging market scale, Mr Baker at JPMorgan expects further growth in inflation-linked products from the upcoming entrants to the eurozone such as Slovakia. The removal of exchange rate risks facilitates the creation of structured products. At the same time, the convergence of low price levels in the region towards those in more developed EU members, and the loss of exchange-rate appreciation as a monetary tool, could both signal higher inflation.

MISSING TARGET Since the last major inflation shock in the 1970s, the most significant change has been the growing adoption of explicit inflation targeting by central banks, which has helped establish greater coherence and credibility in monetary policy.

For Andrew Cole, head of asset allocation at Baring Asset Management, the implication is that benchmark rates will be hiked hard to prevent price expectations getting out of control. This means the real cost of cash should be higher than in recent years, making a significant allocation to cash a suitable response to higher inflation.

“Cash is an appropriate counterbalance to risk assets: it is cheap to manage and has few hidden costs,” says Mr Cole. “Hedge funds and funds of funds may find it hard to beat cash-based returns.”

Based on the same principle, BarCap has created GEMS, an inflation proxy for emerging markets that have no existing indexed products. This is a money market product that takes one-month synthetic deposit rates across 15 countries and overlays one-month non-deliverable currency forwards, to capture a policy response that could include either or both of higher benchmark rates, and exchange rate appreciation in the case of managed regimes such as China and Russia.

Of course, cash will be rather less rewarding if central banks fail to control inflation and real rates become ­persistently negative. Recent research by Ousmene ­Mandeng, head of public ­sector advisory at Ashmore Investment Management, shows that of 11 inflation- targeting emerging markets, only Brazil is on target, while average real policy rates in the non-targeting regimes have already turned negative since the start of 2008.

Mark Farrington, head of currency management at Principal Global Investors, has unnerved central bankers he meets by warning that inflation targeting itself may not survive the current crisis, if the targets are missed for so long that they cease to anchor expectations.

He believes this could happen, because monetary policy may be underestimating inflation risks by focusing too much on the lessons of the 1970s, including a definition of core inflation that is based around tracking wage increases.

“In the 1970s, we’d already had about five years of 8%-plus pay rises in the US and Europe before OPEC even began to turn the screw, but this time wages could be the stable factor,” he says. “It could be logistics, transport, packaging and the like that becomes the main channel for second-round inflationary effects, so we may need a new definition of core inflation.”

Mr Farrington is inclined to prepare for turbulent markets by building positions in the biggest net creditor countries with the lowest interest rates – the US, Japan and Switzerland. He expects their currencies to strengthen as they repatriate capital and raise rates. For those more confident of ­monetary policy success, JPMorgan offers European Central Bank credibility notes, which pay a high coupon for each month that eurozone inflation is on target.