The role of structured products in the fight against inflation

Monetary measures, such as quantitative easing, have helped keep a fragile global economic recovery going in the aftermath of the financial crisis, but flooding the markets with liquidity has raised concerns that an inflation surge may follow.

In the UK, inflation figures for early 2011 have been running well ahead of analysts’ forecasts, with the official government target measure, the consumer price index, hitting an annualised rate of 4.4% in February.

And though inflation is running at lower levels in the eurozone, concern is growing. Data from the EU statistics agency Eurostat shows that annualised eurozone inflation rose to 2.6% in March, from 2.4% in February, which is well above the European Central Bank's (ECB) long-term 2% target. The euro rose upon release of the latest figures, as investors bet that gradual ECB rate hikes were on the way during 2011. Sure enough, that tightening cycle started in April 2011, when the ECB raised its benchmark refinancing rate by 25 basis points to 1.25%.

Demand for protection

Inflation is of particular concern to high-net-worth individuals with accounts at private banks, who have large portfolios of financial assets to protect. But even in the mass retail market, there is a growing demand for some sort of protection. Strategies vary. Some investors want to address the inflation rate directly with structured products linked to official inflation indices. But many investors feel more comfortable with interest rates than inflation indices, and prefer products on underlyings, such as the European interbank-offered rate Euribor, which should increase if central banks see the inflation threat growing. There are also 'best of' structures with a pay-off based on a combination of inflation and interest rates.

There is also a traditional role of commodities as a hedge against inflation, and oil and precious metals underlyings are currently generating plenty of demand, whether through structured products or exchange-traded funds (ETFs). And another group of investors prefer to simply search for yield in the hope of outrunning the inflation rate, for example, by generating a high coupon linked to equity underlyings.

“Clearly there are inflationary concerns at the moment and throughout last year we have seen growing demand for products directly linked to an inflation index, inflation-linked bonds, hybrid equity and inflation trades, as well as trying to protect against rising inflation through commodity underlyings," says Jane Balen, head of private banking coverage, Europe, at Barclays Capital in London.

Commodity products

Interest in inflation-linked structures continues to rise as inflation expectations have increased during the first half of 2011. Barclays Capital structures trades for private banks across Europe, for distribution to their high-net-worth clients. Products are both structured according to ideas generated by Barclays' own research, and tailored to specific requests from private banks and their clients.

Some inflation-linked trades closed by Barclays Capital in recent months include a five-year leveraged Delta-1 (one-for-one) tracker on eurozone inflation, and a five-year principal-protected inflation-linked note that pays a 2.3% coupon in the first year, and after that the maximum of the floor and year-on-year inflation. The floor starts at 2.3% and steps up by 50 basis points each year. The most commonly used inflation index is the Eurostat eurozone harmonised index of consumer prices, excluding tobacco, though Barclays Capital is also seeing demand for trades based on Spanish inflation, or even US and Asian inflation.

“The most commonly traded commodity-linked products typically involve a well-diversified basket, for example, oil, base metals, precious metals and agricultural commodities," says Ms Balen. “For a while, market conditions made it difficult to structure products with 100% principal protection, but more recently a number of commodity curves have been shaped in such a way that it is possible to provide 100% capital protection on a five-year trade and still give 100% upside participation in a diversified basket of commodities."

Protected equity risk

Société Générale is also seeing a growing awareness of the inflationary threat from its clients, says Alexandre Houpert, London-based head of exchange-traded products for UK and northern Europe at the bank. He says requests for inflation products have picked up since the start of 2011, in particular, as the topic becomes a key concern for investors.

For sophisticated high-net-worth individuals, who might, for example, have a sizable mortgage and want to protect themselves against rising rates, one solution is a tracker linked to three-month sterling Libor. The return is directly linked to interest rates prevailing on expiry date. Another solution is a classic ETF based on inflation-linked bonds. But investors are also addressing the inflationary threat simply by looking for high-yield products, rather than buying a product specifically linked to inflation indices or interest rates.

"It is possible to generate high-target yields by placing capital at risk in the case of a large fall in equity markets, and various autocall structures are popular at the moment," says Mr Houpert.

For example, Société Générale has seen strong demand for its SG92 UK 8.5% Defensive Autocall, which is designed to generate 8.5% a year over five years, provided the FTSE 100 closes above 5900 on each anniversary date. The product will expire early (hence the name Autocall) if, for example, the FTSE 100 is above 5900 on the next anniversary date, which is November 18, 2011. Capital is protected as long as the FTSE 100 is not below 3700 on the final expiration date (November 13, 2015), which is the type of low barrier that investors are typically comfortable with.

Another variation on the theme is range accrual, for example, a product that generates 20.5% over three years, with a small coupon generated each day the FTSE 100 closes between 4500 and 7000. Capital is again protected with a low barrier. The FTSE 100 would have to fall below 3000 upon expiry for investors to lose their capital.

In the German and Swiss markets, HSBC Trinkaus & Burkhardt has also been structuring inflation-themed products. One example is a product issued at the back end of last year in Switzerland that partially benefits from rising interest rates and so acts as a hedge against inflation.

The Floater Barrier Reverse Convertible on the Euro Stoxx 50 was in subscription last October and is listed on the Scoach segment of SIX Swiss Exchange. It is a three-year product paying quarterly interest set at a minimum return of 2.8% a year, to which three-month Euribor is added. This was 0.987% as of October 14, 2010, but will clearly rise if a surge in inflation takes place. The issuer and calculation agent is HSBC Trinkaus in Germany. The product is denominated in euros. Capital is fully protected as long as the Euro Stoxx 50 does not fall more than 65% from the starting level. Low barriers of this kind are popular with investors, instead of guaranteed capital protection, as it allows for a better payoff, while the investor can take their own view of the likelihood of such a big drop in equity markets.

Rate rises on the way

As with most structured products, the investor is additionally exposed to the credit risk of the issuer. In today's market, investors are not as nervous as they were immediately after the collapse of Lehman Brothers, but nonetheless pay close attention to the name of the product provider. Düsseldorf-based HSBC Trinkaus is a long-established private bank, which enjoys the support of its AA rated parent company HSBC.

“Most investors are convinced that inflation is going to get stronger in the coming years, and our third-party distributors are telling us that their clients want products that are linked to rising interest rates,“ says Heiko Weyand, director of marketing retail products at HSBC Trinkaus. “Many products that have been launched since last autumn are linked to Euribor or Libor."

HypoVereinsbank in Munich, which is part of the UniCredit Group, distributes products via its own branch network to both high-net-worth individuals and mass retail clients, as well as acting as provider of products for third-party distribution by private banks and brokerage houses across Germany.

"There is growing awareness of inflation and German investors are protecting themselves with products linked to the official inflation rate, as well as linked to interest rates or with gold underlyings with or without the currency exposure," says Dominik Auricht, specialist for structured investment products at HypoVereinsbank's structured products platform onemarkets in Munich.

One product recently launched under the new HypoVereinsbank onemarkets brand is the HVB 3.35% Crelino Inflationsanleihe linked to Deutsche Bank. This five-year note pays a minimum of 3.35% per annum or the eurozone consumer price index (excluding tobacco) annual rate if this is higher than 3.35%. The yield enhancement is achieved with the help of a credit-linked mechanism on a reference entity, in this case Deutsche Bank. Capital is protected as long as there is no major credit event at Deutsche Bank over the life of the notes.

Exchange-traded funds

Investors are also buying ETFs, which do not feature capital protection, including funds based on baskets of inflation-linked bonds, such as gilts. Another variation is tracker certificates, such as a product launched last year by Bank Vontobel in the Swiss market which references five different inflation-linked bonds from AAA rated French and German issuers. And others are simply buying products with a short one- or two-year life, so that they can re-assess the situation if inflation does surge.

"Investors clearly are concerned about inflation, but are continuing to buy products with a fixed coupon over two years, which suggests that they view inflation as a threat, but further down the line," says David Moroney, global head of retail structuring and structured funds at RBS global banking and markets in London.

"In addition to direct inflation plays, we are seeing a lot of demand for commodities underlyings, which some investors may be buying because of inflation concerns," adds Mr Moroney.

RBS products include the New York Stock Exchange Arca Gold BUGS Index ETF, which gives exposure to 16 gold mining stocks that make up the index. The Rogers International Commodity Index Agriculture ETF uses futures contracts to get exposure to 22 agricultural commodities including corn, cotton, sugar, wheat and coffee. And the Rogers International Commodity Index Metals ETF uses futures contracts to gain exposure to 10 metals, including gold, aluminium, copper, zinc and tin.

But the environment remains very volatile, and discretionary wealth managers and family offices are aware that they could incur large losses, and are often looking for some sort of capital protection element. For example, Brent crude was at only $61 a barrel in March 2009, and between January and November 2010 traded in a tight range between $79 and $89. But after starting to move up last December, it suddenly surged in price to hit $114 in March.

Across the pond

Caught between volatile equities markets and hard-to-predict commodities prices, US investors are also looking to diversify their portfolios, while keeping one eye on the looming threat of inflation. In the US, the second round of quantitative easing (QE2) has boosted economic activity, but there are uncertainties about its impact. The US Federal Reserve announced last November that it was trying to keep the fragile recovery going by purchasing $600bn in long-term securities over eight months. It will also reinvest an additional $300bn in treasuries with the proceeds of earlier investments. The entire $900bn programme will be completed by the end of the third quarter of 2011.

A wave of inflation could potentially follow. An inflationary bubble post-QE2 in the US would dramatically increase global investors’ awareness of the inflationary threat and likely lead to a big increase in demand for structured products with inflation index or interest rate underlyings.

"At the moment many investors are happy to buy products with a life of 12 or 15 months with equity underlyings [as] that is the foreseeable future with regard to inflation," says one banker. "But for longer-term products, investors are worried about protecting their wealth and increasingly want to see some sort of inflation-based solution within the structure."