Risk solutions house of the year: NatWest Markets

Risk Awards 2020: UK bank blazes Libor transition trail; solutions span NPLs to forex forwards

Kieran Higgins, Harsh Shah, Scott Satriano

Photo: Juno Snowdon

When the UK’s markets regulator triggered the start of a global race to replace the Libor interest rate benchmark in July 2017, the sterling market had a headstart. With the local replacement rate, Sonia, already in use for overnight indexed swaps, sterling market participants had a chance to blaze a trail the rest of the world could follow.

Early on, NatWest Markets saw this as an opportunity. The bank has since played a part in nearly all the big moments in the sterling transition – landmark Sonia bond and loan deals, as well as some major derivatives portfolio switches.

“Having chosen a rate that was already in existence and a product we already trade in the derivatives space, it was a market that got up and running quicker. And being a UK-based bank, this is an area we really felt we should be fully engaging in,” says Iain Budge, a director in the UK and Ireland financial institution origination and solutions team at NatWest Markets.

Last year, the bank acted as one of two structuring advisers for the first Sonia-linked bond of the transition era, from the European Investment Bank (EIB) – during which it helped design the coupon structure for overnight rates that would serve as the benchmark for future issuances in sterling, euro and US dollar.

While new issuance followed, no-one had yet tried to amend an existing Libor bond to reference Sonia. This changed in June 2019, when Associated British Ports sought approval to change a £65 million Libor-linked floating-rate note to Sonia.

NatWest Markets was sole solicitation agent for the change, requiring the bank to design a way to capture the basis between Libor and Sonia for the remaining term of the bond so the new coupon – Sonia plus the basis – would be acceptable to investors without having to pay them an extra fee.

Investors accepted the proposal, and, with some small tweaks, NatWest Markets used the same structure to switch notes for Nationwide Building Society and Santander UK. Lloyds Banking Group also used a similar structure for its switch in October.

In the lending market, the bank struck the first Sonia-referencing corporate loan with National Express, using the same coupon design it helped pioneer in the bond market with EIB. And it reused its FRN-switch methodology when changing a South West Water loan from Libor to Sonia in October – another first.

NatWest Markets was there on the trading side, too. When Nationwide wanted to move to a Sonia-based balance sheet, the building society turned to NatWest Markets for help. The change required existing Libor swaps to be linked to Sonia instead, generating a need for some big basis trades. 

Having chosen a rate that was already in existence and a product we already trade in the derivatives space, it was a market that got up and running quicker

Iain Budge, NatWest Markets

Over a number of weeks in the third quarter of 2018, NatWest Markets provided Sonia-Libor basis positions to Nationwide with a £3 million total sensitivity to a one-basis point move in rates. NatWest Markets facilitated this trading by looking for pockets of opposing liquidity, minimising the impact on the basis itself.

Richard Merrett, head of derivatives at Nationwide, says NatWest Markets ended up being the building society’s largest counterparty for Sonia-Libor trades.

“NatWest Markets has really stepped up on the whole Libor-to-Sonia transition; it was one of the first to actively engage with us to support our switch to Sonia, dedicating significant resources to the challenge. When it came to execution, the bank offered fantastic liquidity and very good pricing on Sonia swaps,” says Merrett.

Outside of Libor, NatWest Markets has built a strong market position in the non-performing loan (NPL) market in southern Europe. The bank has been an important player in the market for Italian-government-guaranteed NPL securities since its inception, but this year took a step into the unlikely-to-pay (UTP) market. This is an €80 billion asset class for loans that are in arrears but not yet classified as non-performing.

NatWest Markets this year provided the first-ever financing of the purchase of a portfolio of Italian UTPs, supporting one sponsor client. In doing so, the bank had to re-underwrite the portfolio, after weighing how likely it was that the assets’ new owner would be able to negotiate repayments.  

“We did our own due diligence on the assets and legal documentation. We also carried out some stress scenarios to make sure the loan is actually repaid, even if these sponsor-to-debtor renegotiations are not completed successfully,” says Patrizia Lando, part of the financial institutions origination and solutions team at NatWest Markets.

The financing, which was for over €100 million, was completed in August. It runs for four years with an option to extend for one extra year if the business plan is on track.

“We spoke to a number of banks and had been declined for a while. NatWest Markets was keen to look into this. They took time to educate themselves on the product, and understand our business and model our portfolio. There was no market standard, but eventually they came up with a structure that was quite good for us,” says an NPL expert at the sponsor.

Moving further east, NatWest Markets worked with Vakifbank, the fifth largest bank in Turkey, on a novel total return swap (TRS) financing of so-called diversified payment rights (DPRs) – a securitisation of future remittances from Turkish expatriates.

A DPR securitisation deal was agreed with Vakifbank, but Turkish banks were then suddenly downgraded in July, putting the issuer below investment grade. This created a problem, as non-investment grade notes issued from DPR programmes that rely on a certain exemption can only be held by parties considered accredited investors under US securities law. Vakifbank could issue anyway, but as bonds are a bearer instrument, there was a risk the notes could end up in non-accredited investors’ hands, putting the issuer at odds with US regulations.

Photo: Juno Snowdon

Harsh Shah

“When they were downgraded, the issuer couldn’t risk the DPR being created in a format that could potentially be sold to non-accredited investors in the US and therefore needed a format that allowed them to have control over who it went to,” says Harsh Shah, head of financial institutions origination and solutions at NatWest Markets.

The only way of preventing that was issuing in a loan format, which allows the issuer to track that the holders are accredited investors. The loan was sold to a bank investor, and NatWest Markets entered back-to-back TRSs with both counterparties to pass on the proceeds to Vakifbank. It took on the correlation risk of the DPR and the Turkish bank, but mitigated this with various triggers.

The deal, with a notional in the hundreds of millions of dollars, was the first ever loan TRS on DPRs. It was executed in October, in a week which saw a flow of negative Turkey stories stemming from its conflict with Syria and threats of sanctions from US president Donald Trump.

“In the middle of rising concerns of potential sanctions towards the Turkish economy, NatWest Markets continued to show its commitment and support not only towards Vakifbank but also towards the Turkish banking sector and economy,” says Ali Tahan, head of international banking and investor relations at Vakifbank.

Back in the UK, NatWest Markets has a strong reputation in the sterling inflation space, and it showed why on an innovative inflation hedge – part of a stake-sale in the Hornsey 1 offshore wind farm, the largest in the world. Ørsted was divesting a 50% stake in the project to Global Infrastructure Partners, worth around £4.5 billion, and the seller was arranging the finance, which was a mix of loans and bonds. Given the wind farm’s revenues were linked to the consumer price index (CPI) inflation measure, some of the bonds were linked to CPI.

Gilt locks are often used as a debt pre-hedge, as they allow a borrower to essentially lock-in the gilt yield at today’s price, which is helpful as the bonds are usually priced as a spread over gilts. Given the CPI-linked debt is priced off the relevant UK government retail price index-linked bond, a gilt lock based on the linker made sense.

This wasn’t straightforward. First, the hedge needed to be appropriately sized to ensure it had the correct sensitivity to a one basis point move in the underlying. And while forward gilt yields are easily viewable, the same isn’t the case for gilt linkers.

“One of the important things here was being able to demonstrate to the client how we formed the price and provided the tools for them to benchmark the bank in a transparent manner. It wasn’t just like an interest rate swap, or even a nominal gilt lock, where it is straightforward to get an accurate price in Bloomberg,” says Greg Handelaar, part of NatWest Markets’s markets infrastructure and utilities origination and solutions team.

NatWest Markets took time to educate themselves on the product, and understand our business and model our portfolio

NPL expert

The gilt lock had to be extended a number of times as the financial close date suffered from repeated delays, and was eventually live for around six months.

In foreign exchange, NatWest Markets put together an innovative hedging solution for Drax, operator of a biomass power plant in the north of England. The company is heavily exposed to the sterling/dollar exchange rate – it buys its fuel from the US in dollars – and typically hedges with forwards, where the forward exchange rate is composed of the current spot rate plus or minus a forward point add-on.

At the time, the positive forward points were very attractive due to the interest rate differential between the two countries, but the spot rate was at very depressed levels, meaning the overall forward rate was not attractive for Drax.

The company still wanted to hedge, so NatWest Markets developed a hybrid product that allowed Drax to lock in the forward points while allowing spot to continue floating for up to six years. When the spot had risen sufficiently during that time, it could be locked in, at which point the product coverts to a regular forex forward comprising the new spot rate plus the previously fixed forward points.

In total, more than $1 billion of this structure has been traded with Drax, with recent tranches including mandatory breaks – these cut the capital footprint of the trade for NatWest Markets from five or six years to one.

“The floating spot forward was immensely successful, enabling us to capture interest rate differentials at all-time highs independently of spot, which was close to all-time lows. We worked very closely with NatWest Markets to develop this ground-breaking solution to match underlying risk more closely with this bespoke solution,” says Lisa Dukes, deputy group treasurer at Drax.