The standard threat to inflation swaps

The market for corporate inflation swaps is fast reaching a crunch point with the looming arrival of International Financial Reporting Standards. Will the new rules scupper this nascent market?

The growth of the inflation swaps market is beyond dispute. Broker trading volume alone exceeded e12 billion in the first quarter of this year, according to UK inter-dealer broker Icap (see figure 1). While determining what proportion of that volume is derived from inflation-paying companies is impossible – banks are unwilling to provide more than the odd well-known examples of activity – anecdotal evidence suggests the market is still small, but growing, especially among utilities.

But this nascent activity may be under threat from the imminent introduction of International Financial Reporting Standards (IFRS) and specifically IAS 39. While the basic principle of inflation swaps is to hedge revenue, they have more often been used to hedge liabilities. Using the inflation swap market in conjunction with issuing fixed-rate debt – the concept of synthetic instrument accounting – has been an important factor in the growth of the inflation swap market, according to Mark Baillie, associate director and IAS specialist within the financing solutions group at Barclays Capital in London.

Under UK Generally Accepted Accounting Principles (GAAP) and most local accounting regimes in Europe, the issuance of fixed-rate bonds and their swapping to inflation can be accounted for as inflation-linked debt. This provides benefits in accounting treatment. And inflation swaps have received generous treatment in almost all local GAAP areas, says Veronique Thomas, a Paris-based financial engineer at SG, the investment banking arm of Société Générale.

While IFRS does not explicitly rule on inflation swaps, it does prohibit the use of synthetic instrument accounting. “Each transaction instead has to be on an individual contract basis and any swap must be accounted for on its own,” says Baillie. “Derivatives must now be carried at marked-to-market value on the balance sheet and the criteria for hedge accounting is very strict, even for vanilla swaps. The complexity of documentation and effectiveness testing show quite clearly that the IASB views hedge accounting as a privilege and not an automatic right.”

Under IFRS, an inflation swap cannot be seen as a hedge of a fixed-rate bond, according to Baillie. Instead, swaps can only be seen as a hedge of inflation-linked cash flows. The effect of this will be substantial, according to most observers. But there is a divergence of opinion as to what constitutes an inflation-linked cashflow. As Thomas notes: “If a company’s revenues are directly linked to inflation through a regulatory mechanism then inflation swaps may be compliant [with IFRS]. But there are many companies for which revenues are linked with inflation, but not directly, and this poses a problem.” Peter Matza, senior manager in the treasury department at European utility RWE, agrees: “Our understanding of the accounting issues surrounding the use of inflation swaps is that unless an [IRFS] reporting corporate has an underlying contractual exposure to inflation there is no positive accounting treatment available.”

The need to link inflation swaps to revenues throws up significant challenges such as the ‘highly probable’ test, according to Barclays Capital’s Baillie. To qualify for hedge accounting, derivatives use has to be based on revenues that can be deemed highly probable – of at least 90% certainty. “But for utilities, it can be difficult to demonstrate that revenues are highly probably more than five to 10 years out because as regulated companies they are susceptible to regulators changing their minds on formulas,” he says. Currently, a typical hedge may extend beyond 20 years.

For retailers – which may hedge against low inflation as it makes it harder to disguise and pass on increases in sales margins – the highly probable test is even harder to pass as their revenues usually fluctuate more and change significantly over time due to factors other than inflation.

David Martin, treasurer at Northumbrian Water – which has not used the swap market in isolation but has securitised an index-linked contract that involved a swap – says he has consulted with auditors about the subject of certainty of income. “There is going to be a change in what is achievable,” he says. “To take out a hedge on income that qualifies for hedge accounting it would have to be restricted to the current regulatory period.”

For Northumbrian Water and many regulated utilities in the UK, regulatory periods are five years – making the attractions of the inflation swap market, which chiefly exist at the long end, significantly weaker. “The banks have a challenge to convince utilities to use these swaps because at a stroke the most attractive feature – the long-term security of revenue – appears to have disappeared,” says Martin.

The second test to qualify for hedge accounting is the effectiveness test. “[Corporates must be able to] prove that any hedge taken out will be effective within the limits of the 80–125% effectiveness test,” says SG’s Thomas. “This means that the mark-to-market valuation of an inflation swap must be an offset of changes in revenues as a result of inflation by a factor of 80% to 125%.” But Michelle Price, who works in corporate treasury consulting at Deloitte, says proving the effectiveness of hedging will be as difficult over the length of a typical utility swap as it would be to prove stability of revenue. “How can you show that the hedge will be effective at 20 years?” she asks.

Barclays Capital’s Baillie says while a utility might be able to pass a hedge effectiveness test it will be hard for it to pass the highly probable test. For retailers it may prove almost impossible for them to demonstrate hedge effectiveness because they are only exposed to elements of the retail price index (RPI) and have an imperfect correlation. “Even for utilities there is some basis risk because revenues are also linked to efficiency and other factors as well as inflation,” he says.

Does the imposition of these tests mean that corporates will no longer use – or consider using – inflation swaps? Guy Coughlan, global head of asset/liability management advisory at JP Morgan in London, believes that may be the case in the short term. “The limiting factor in the growth of the inflation swaps market has always been the lack of inflation payers,” he says. “In the short term, the change to IAS 39 may worsen that situation.”

Corporates face two choices with regard to inflation swaps, according to Coughlan. “They can either avoid hedging, thereby increasing their economic risk, or they can hedge anyway and live with the additional earnings volatility,” he says. If corporates choose the second option, “real economic value” will have to be evident, according to RWE’s Matza. In addition, corporates using swaps that do not qualify for hedge accounting will have to communicate enough detail to investors about their hedging strategy to enable them to see through the potential accounting volatility to the underlying economic reality, Coughlan says.

For the lucky few – such as Welsh water company Glas Cymru, which as a not-for-profit company does not have to justify its actions to shareholders – that volatility will be tolerable because earnings per share is not the central criteria on which it is judged. But for most other utilities – and certainly any retailers willing to brave the fluctuations of mark-to-market derivatives – that explanation to shareholders will have to be convincing.

Barclays Capital’s Baillie says most of his clients believe it will be possible to justify potentially volatile hedges to investors. “Generally equity investors can differentiate between profit and loss volatility caused by revenue changes and volatility caused by marked-to-market derivatives. Bond investors and credit analysts tend to be more focused on cashflows,” he says.

The idea that investors might accept greater profit and loss volatility as the price of greater long-term stability aside, banks have been trying to devise products that work more effectively under IAS 39. “We are trying to help clients find a balance where the economic effectiveness of hedges is maximised and the impact on profit and loss is minimised. Those sorts of products are already appearing in the interest rate market and inflation will follow,” says Edward de Waal, director and head of origination for European inflation-linked products within the financing solutions group at Barclays Capital in London.

SG’s Thomas adds: “There are ways of minimising profit-and-loss volatility, which all banks have been trying to develop.” She says these ideas are currently proprietary but either focus on the search for correlation between revenues and derivatives use or involve splitting products into various components – some of which have less dramatic effects on profit and loss.

The most obvious way of hedging liabilities and revenues is through the inflation-linked bond market. “In general IAS 39 has led to a growing appetite for embedding derivatives into debt,” says JP Morgan’s Coughlan. “Although the inflation-linked bond market has been around for some time, many corporates have still not yet recognised their risk management benefits and the important role they can play in liability management.”

At present, the inflation-linked bond market – thought to be worth around $450 billion – is dominated by sovereigns, and corporate issuance has tended to be seen as opportunistic. In addition, there has been little activity at the long-dated end of the market. The maturity profile and perception of the inflation-linked bond market will have to change substantially if it is to become a real alternative to the fixed and floating markets for corporates.

Ultimately, it is difficult to assess the likely impact of IAS 39 on the market for corporate swaps because the scale of the market is so unclear, according to Thomas Decouvelaere, a financial engineer at SG in Paris. But Barclays Capital’s De Waal says: “You must remember that this is not all bad news – accountancy shouldn’t be driving the business or economic rationale, and the lessons from the introduction of FAS 133 in the US indicate that the market rapidly adapts to the new situation. These rules are about promoting openness on risk management to stakeholders and ultimately that can only be positive.”

As banks and corporates see little chance of IFRS rules changing before they are implemented in January 2005, companies should work with the rules as they stand even if some of them “just don’t make economic sense”, according to SG’s Thomas. For everyone, the introduction of IFRS is going to be a learning curve. As she notes: “Ultimately, treatment will be down to the interpretation of auditors.”

But the auditors can provide little more certainty at the current time. “It will come down to case studies and auditors proving what is possible,” says Price at Deloitte. “The big four have not come up with the same answers yet but once IFRS is a reality and people see what is possible, certain practices and measures will rapidly become accepted. Within a year there will be broad agreement.”

1. Inflation swaps turnover in the broker market

Inflation swaps or bonds?

Paying inflation through a swap offers companies that have revenues linked to inflation, such as utility operators, infrastructure providers and even retailers, the ability to swap part of their revenues for either a fixed return or more usually a payment tied to Libor. The advantage to corporates of inflation swaps is the ability “to crystallise their revenues going forward”, says Veronique Thomas, a Paris-based financial engineer at SG, the investment banking arm of Société Générale. “It means that the company has greater certainty over its future revenues.” Swaps are long-dated – often more than 15 years – given the nature of utility companies, explains Guy Coughlan, global head of asset/liability management advisory at JP Morgan in London. “Inflation is a long-term risk. Its effects are persistent and cumulative. It doesn’t make so much sense to hedge inflation in the short term because the immediate inflation outlook is usually predictable. But over the 30-year lifespan of a fixed asset whose return is inflation-sensitive, the compounded impact of inflation could be enormous.” Edward de Waal, director and head of origination for European inflation-linked products at Barclays Capital in London, says that, so far, the main use of inflation swaps has often been to back them with long-dated financing so that the maturities of outstanding bonds match the swap. Therefore, instead of being a revenue swap with inflation-based revenue changed to fixed or floating rates, the swap allows a corporate access to inflation-linked funding despite borrowing in the non-inflation market. Not everyone sees the benefits of such hedging. “Surely it’s much more straightforward to issue retail price index-linked debt?” asks Neil Webb, treasurer of Welsh water company Glas Cymru. “Our revenues are linked to inflation, so our debt should also be. We’ve never had a problem in raising index-linked funding. To swap our revenues out of inflation so that we could raise non-inflation-linked debt would be a roundabout way of matching liabilities and assets.” Peter Matza, senior manager, treasury at European utility RWE, adds: “In the UK, Thames Water [which is owned by RWE] does have underlying contractual exposure to inflation-based price increases. But to date it has not found sufficiently attractive opportunities in inflation swaps to warrant their use. [Instead] it has issued in the inflation-linked bond market.” Alison Stevens, manager, capital markets at National Grid Transco in London, agrees that inflation-linked bonds are the obvious way of hedging borrowing to revenues. And she says that the inflation swap market for corporates raises other concerns. “Another significant reason [for the limited uptake of inflation swaps by corporates] is the nature of the swap contract, which as it reaches maturity becomes more out of the money (we owe them more money), until settlement. As that occurs, banks are taking on greater credit exposure and may therefore require hefty credit charges, collateral and mutual breaks. As a consequence, the costs of inflation swaps are a disincentive to their use.” She adds: “To date the inflation swap market has been one-sided, with more people wanting to receive inflation than wanting to pay inflation.” The attractions of inflation swaps for inflation receivers, such as pension funds, which need to find assets to match their inflation-linked liabilities, have always been clearer than for inflation payers such as utility companies, she argues. Bankers recognise that despite a few well-publicised deals – such as the BBC’s use of an inflation swap as part of its $813 million sale and leaseback securitisation in July 2003 (Risk January 2004, page 12) – inflation swaps have yet to really take off among corporates. “For many companies, inflation swaps are still more of an idea than a reality,” concedes Thomas Decouvelaere, financial engineer at SG in Paris. Iain Wilson, associate director, derivatives trading, at HSBC in London, adds: “People are still getting their heads around it, but I wouldn’t say that the market is wholly skewed toward inflation receivers – there are corporate users out there.” Wilson also counters that the inflation-linked bond market – even where it is mature, as in the UK – is open only to selected names and often cannot offer the maturities and size of deal an issuer wants. “The swap market has vastly more capacity and products can be tailored to individual requirements.” He adds: “It is widely known that utility companies want more index-linked liabilities but if they are not available as debt then it makes sense to create them as swaps.”