Adding an inflation dimension to a liability portfolio opens up new strategies for asset liability and debt managers, say ABN AMRO’s Brice Benaben and Sebastien Goldenberg.

The surge in sovereign inflation bonds supply over the last few years and the parallel sharp development of US and European inflation derivatives markets has increased the liquidity and flexibility of inflation products. This means that corporates and financial institutions can add a new dimension – inflation – to their financial strategy and risk management.

The best-known inflation index is the Consumer Price Index (CPI). It tracks the price of a basket of goods and services (retail prices) and housing. There are other classic measures: The Gross Domestic Product deflator, the widest measure of inflation, is well correlated to the CPI; the Producer Price Index is a narrower measure mainly tracking manufacturers’ prices. Most inflation-linked financial products are linked to the CPI, except in the UK, where they are linked to the Retail Price Index, which is closely related to the CPI.

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Reducing the expected funding cost

An issuer of inflation-linked bonds is expected to save the so-called inflation premium. If forward inflation rates perfectly predict future realised spot inflation rates, the long-term cost differential between the nominal rate and inflation-linked debt should be zero.

However, empirical studies show that an issuer of inflation-linked debt can expect to save up to 0.5% because investors in inflation bonds are prepared to pay a premium in order to hedge against inflation risk.

In other words, forward inflation rates are expected to over-estimate real inflation and the issuer could pay lower coupons than the yield implied by the market.

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Reducing total earnings volatility

Corporates have various sources of inflation risk in their operations, including salary payments, real estate rent revenues or payments, sales revenues (for example, in the food retail sector) and pension funds payments.

In general, cyclical businesses have operating results well correlated to inflation. When inflation is high operating results are strong and vice versa. Therefore, linking part of the liability to inflation can significantly reduce total earnings fluctuations.

Could a floating rate debt strategy achieve a similar result? Usually risk reduction is less efficient. First, operating results generally have a stronger correlation to inflation than to floating nominal rates. Second, the relationship between inflation and short-term rates is unstable: for example, on average, the correlation between year-on-year US CPI and one year Libor rates has been 63.5%, but in the monetary tightening period 1993-1995, the correlation was –22.4%.

The definition of a funding strategy involving inflation products requires a global analysis of inflation risk. ABN AMRO’s approach is to stress-test the income statement and balance sheet with the forward inflation and rate paths simulated by our proprietary model, taking into consideration accounting constraints imposed by IAS 39 and FAS 133.

Let’s take an example of a firm with revenues and expenses correlated to inflation (say, sales correlated by 50% and personnel costs by 80% to inflation); one can test the impact of four funding strategies on the expected net profits. The main conclusions are:

  • Floating rate debt and inflation-linked debt smooth the expected profit in time.
  • Inflation debt increases the expected profit slightly because of the saving from the inflation premium.
  • The risk of a drop in profit is significantly decreased while adding inflation-linked debt; an optimal ratio is 30% fixed rate debt/30% floating rate debt/40% inflation-linked debt.

Implementing inflation views

For active liability managers, getting the right fixed rate/floating rate debt mix in the current, low rate environment essentially means choosing between two strategies: increasing the floating nominal rate debt – thus benefiting from a positive carry between a fixed rate and lower short-term rate, while being exposed to a potential rate increase; or fixing the funding cost and losing the carry.

Both strategies rely on the timing of monetary policy, which is particularly difficult to assess in a monetary transitional period. Also, it is easier to have an opinion on inflation rather than interest rates. For example, debt managers may expect a lag between the inflation and the monetary cycles:

  • The short rate level (difference between the nominal rate and inflation) is close to zero in EMU and has even been negative in the US (see graph 3). To come back to average historical levels (2.5%), the nominal yield must increase significantly relative to inflation.
  • The transmission of rate hike as expected by the market into the real economy, and particularly to inflation, may take several months. This would imply that short-term rates should increase before the inflation increase.

Debt managers can then minimise the cost of funding in line with their view by linking part of the debt to inflation. Floating rate debt significantly reduces the cost of funding compared to fixed rate debt up to 2006, but increases it thereafter. If inflation is high, the cost of inflation-linked debt will be higher and vice-versa.

  • If views are realised, the cost of inflation-linked debt is lower than fixed rate debt and floating rate debt. The main risk would be that the nominal interest rates remain low while inflation increases (stag-flation scenario).

Adding an inflation dimension An immediate and straightforward way to add an inflation dimension to a liability portfolio is to issue an inflation-linked bond. Another is to create synthetic inflation-linked debt using inflation derivatives. Similar to the way that existing fixed rate debt can be transformed into a floating rate debt, nominal debt can be swapped into an inflation-linked debt.

The increasing liquidity of inflation-linked financial products opens up new strategies to asset liability and debt managers – adding an inflation dimension to debt can significantly mitigate net earnings volatility. For debt managers, linking part of the debt to inflation helps to reduce the interest cost volatility and the expected cost of funding. Moreover, it gives more flexibility to active liability managers to implement their market views.

Brice Benaben is head of inflation structuring at ABN Amro. Sebastien Goldenberg is head of inflation trading at ABN Amro

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