Inflation is once again being discussed and inflation-linked instruments have stepped back into the spotlight. Natasha De Teran finds that derivatives have as much of a role to play as inflation-protected securities.

Bill Gross, CEO of the world’s largest bond fund, Pacific Investment Management Co (Pimco), kicked off 2004 by coming out in favour of inflation-linked bonds. US Treasury notes that protect against faster inflation are the best investment as the economy grows, he said: “Tilt your Treasury duration in the direction of inflation-protected securities. We have been.”

Mr Gross’s words will have provided a welcome boost to business on inflation-linked issuers’ and originators’ desks, but business is already more than strong. As commodity prices soared and interest rates and corporate earnings rose at the end of last year, inflation fears were rising not far behind.

But although the appetite for inflation-protected assets is poised to reach an all-time high, knotty questions about supply meeting demand remain. The inflation-linked bond market is still relatively young: the UK government began issuing inflation-linked bonds in 1982 but the US and France did not begin until 1997 and 1999 respectively. Since then, France has ramped up its inflation-linked issuance sizeably, Italy and Greece issued bonds during 2003, and similar plans are now being discussed in Germany, Switzerland and Japan.

Even so, and despite demand growing on all sides, the inflation-linked bond market is still worth less than $1000bn globally.

Thankfully for both investors and bankers, the inflation derivatives market has developed strongly, particularly in Europe. Inflation derivatives, which can be tailored to almost any requirement, can step in where index-linked bonds are unavailable or unsuitable for a particular requirement. In Europe, bankers even claim that at times the inflation derivative market is “wagging the dog” – growing faster than the physical equivalents and offering opportunities that are not otherwise available. Now bankers are hoping that a similar market will develop in the US.

Arun Gandhi, European inflation swaps trader at JP Morgan in London, says: “The US inflation swap market only really started in the middle of last year, while in Europe the market has been active for three years. As a result, the European market dwarfs the US inflation swap market at the moment. But the US is growing quickly: during the first week of January we saw more volume in the US than we did in Europe.”

Popular instruments

The most commonly used inflation derivative, inflation-linked swaps, offer an alternative and effective way of matching inflation-linked liabilities. In a basic inflation swap, two counterparties exchange an agreed payment for the compounded annual inflation rate at maturity. Because the swap is tailor-made, it can be used to match the end users’ liabilities more closely than an index-linked bond could. For example, the period over which inflation is received can be extended or the shape of the inflation receipts can be tailored to the shape of the liabilities.

Inflation-linked swaps can also be used to create synthetic versions of inflation-linked corporate bonds, which is particularly useful given the minimal size of the inflation-linked corporate bond market. By buying a fixed-coupon corporate bond and receiving inflation on the swap, the pension fund effectively creates the cash-flow profile of an inflation-linked corporate bond.

With the retail sector’s growing demand for inflation protection, the potential scarcity of assets and pension funds’ need to adapt any publicly available assets to suit their own liabilities, many expect the inflation swaps market to grow at an unprecedented rate this year. France, which is already one of the most buoyant markets for inflation bonds and derivatives, is set for volumes to rise explosively.

Amaury D’Orsay, head of government bond desk including inflation products at investment bank SG in Paris, points to the local deposit accounts – the so-called Livret A and Codevi accounts. From July this year all such accounts in France will be linked to Euribor and French inflation in equal measure.

“Already E350bn is invested in such accounts but from July all the banks wanting to cover their risk on these new deposit accounts will have to protect themselves against local inflation rates. This will mean that demand for inflation derivatives, particularly inflation swaps, will soar in France,” says Mr D’Orsay.

It will undoubtedly be the larger French banks, like SG, that are best poised to serve these needs, but there are other avenues for banks. Another inflation derivative that is fast growing in popularity is based on Deutsche Bank and Goldman Sachs’ economic auctions. The two banks are widely considered to be among the strongest in inflation derivatives owing to their willingness to take on proprietary positions and their strong client networks and origination capabilities. In a prescient move, they introduced the first options auctions based on inflation data in May last year.

These auctions, which give traders the first direct instruments for hedging against short-term inflation risk, are now held on a regular basis and are based on the monthly eurozone inflation statistic, the Harmonised Index of Consumer Prices (ex-tobacco) (HICP).

Room for growth

According to Oliver Frankel, managing director, economic derivatives at Goldman Sachs in New York, the European auctions have taken off well but there is still a lot of room for growth, particularly in the hedge fund and broker-dealer communities. “We also expect more real money investors to come on board as the auctions develop. Some real money investors have already signed up and are preparing to participate in the auctions,” he says.

A next logical step for the two banks might be to introduce a US equivalent, especially given the weakening dollar’s effect on local inflation. However, the Chicago Mercantile Exchange (CME) is also joining the inflation bandwagon, listing the first inflation-linked contract this month, which will be based on the widely-followed US inflation figure, the US Consumer Price Index (CPI).

Although precise details of the CME’s new contract have only recently emerged, appetite appears strong. According to the Bond Market Association’s Inflation-Linked Securities Survey issued in late December last year, 72% of institutional investors said they would utilise a futures contract based on the CPI.

Support for CME move

Most bankers are equally supportive of the move. Rashid Zuberi, co-head of interest rate derivatives structuring at Deutsche Bank, says: “The CME’s contract will definitely make a big difference. At the moment, US investors mostly buy inflation-linked bonds, while the swaps market is only beginning to develop. The CME contract will improve liquidity and help to promote the structured side of the market.”

Georges Elhedery, executive director in charge of interest rate and inflation exotics at Goldman Sachs in London, says: “I think this contract is going to be very useful. We have already started offering a similar instrument in Europe through the inflation auctions we run together with Deutsche Bank. Since launching these last year, we have seen an increasing amount of interest from traders and investors, who use the auctions to hedge reset risks on their bond positions and smooth out returns. I expect the US contract to gain a similar following.”

Mr Elhedery expects that when liquidity in the new contract builds up, the risk premium in US inflation swaps will diminish, leading to increased liquidity and a narrowing of the spread to Treasury Inflation Protected Security (TIPS) break-evens. He also hopes that the CPI contract will help to spur the growth of retail and other structured products in the US.

Keeping up revenues

One constant worry for structuring departments at banks is keeping ahead of the growing commoditisation of their products. As soon as products become mainstream, margins are compressed and volumes must be multiplied by considerable factors to keep up revenues. With one of the more lucrative and complex elements of their business looking set to go on exchange, structuring departments could be forgiven for their resentment. However, most appear more than positive about the effect that it will have on their business.

Mr Zuberi says: “The arrival of a listed contract will not hugely affect the over-the-counter and structured side of business, as customers have very specific cash-flow profiles that need to be hedged.”

Mr Gandhi agrees. “Most of our trades tend to be customised solutions, tailored to investor needs. The arrival of an exchange-traded contract will not replace these sort of trades but will act as a helpful complement, enabling the market to put more exotic structures together,” he says.

Some players are more sceptical, however. Mr D’Orsay concedes that a short-term contract like the CME’s that replicates the monthly fixings of the CPIs will be “quite useful” for the markets, but he believes that a long-term contract (five or 10 years) would not be. “The OTC markets are sufficient enough to fulfil the market’s needs on a long-term hedging basis and many swap traders will have an interest in the contracts not taking off. Already we have seen how such a contract [Swapnote] has failed to attract a following in the interest rate swap market for similar reasons,” he says.

He suggests that a reasonable alternative to an exchange-traded contract would be provided by a swap clean-up service like Icap’s TriOptima, which has already been running in the interest rate swap market. The service effectively allows banks to collapse their swap portfolios, releasing them from capital and credit charges and eliminating costs.

“We believe that if we get to a situation where a lot of books are piling up swaps and have a lot of CPI hedging risk, one of the brokers might try to clean up the books – like Icap’s TriOptima has already done in the interest rate swap market. That would obviate the need for such a contract,” he says.

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