Missing links

For utility companies with income streams linked to inflation, using inflation derivatives to match assets with liabilities easily and relatively cheaply must be the easy option? If only it were that simple. By John Ferry

Tom Fallon, group treasurer of Warrington-based United Utilities, which owns and operates electricity and water networks in the northwest region of England, has developed a healthy skepticism of inflation derivatives and index-linked bonds over the years. Like many finance experts at UK utility companies, which typically have inflation-linked assets, the thought of raising index-linked capital very much appeals, but Fallon is holding back, for the moment at least.

He cites a fear of getting ripped off in the market as the reason for not issuing index-linked debt. “We issued £50 million ($91 million) worth of 30-year inflation-linked bonds a few years ago, off our medium-term note programme. We would be only too pleased to increase the size of the issue, but we wouldn’t want to do it in a way that transfers value from our shareholders to a clever hedge fund manager,” he says. And neither is he taken with the thought of replicating index-linked bond financing through issuing standard bonds supplemented with an inflation swap overlay. “It is actually quite difficult to replicate the cashflows of an index-linked bond with swaps,” he says.

A utility company looking to raise inflation-linked capital has two basic options to hand. It can either issue index-linked bonds, where the instrument’s principal and interest is linked to an inflation index – in the UK this is typically the retail price index (RPI). Or, as a way of replicating this kind of instrument, it can issue standard bonds but at the same time enter an inflation swap, thereby synthetically index-linking the debt (see box). On the other side, pension companies like to invest in inflation-linked bonds because they provide a natural hedge against their liabilities – the pensions that they have to pay out tend to go up with inflation, so the economics of their liabilities are similar to an index-linked bond in reverse.

It sounds like the sort of situation where, with the help of a good investment banker sitting in the middle, everyone’s asset and liability management problems can be solved. But it’s not that easy. Fallon’s problem with inflation-linked debt is that he believes he will be arbitraged against the government index-linked market by a “clever hedge fund manager”. He says that in recent years, utilities have had to pay a “significant premium” of up to 40 basis points (bp) for issuing index-linked debt rather than conventional bonds, opening the way for arbitrage, although at the moment Fallon says the gap is more like 15 to 20 bp.

“If a company were to issue an index-linked bond and pay an extra 40 bp, then a clever investor, especially a hedge fund, could buy that index-linked bond and then do a switch trade in the government debt, where they could sell the index-linked government bond and buy conventional government bonds,” says Fallon.

“They have now essentially added a conventional bond issued by the company to their portfolio, but they’ve got an extra 40 bp for the same credit risk.”

Banks that structure inflation-linked bonds acknowledge that a premium is paid by the issuer, but say that an investor in this type of debt has to accept more credit risk than on conventional bonds because the nature of the cashflows under an index-linked bond are back-ended – concentrated towards the end of the investment period.

“You could argue that the investor is taking on more duration with the index-linked bond and has to be compensated for that,” says Mark Beaumont, director of corporate risk solutions at Royal Bank of Scotland (RBS) in London, which has closed a number of inflation deals for UK utilities.

So if issuing index-linked bonds is not an option for United Utilities at the moment, then what about the second option – a standard bond with an inflation swap? Fallon says the cashflows on such deals don’t match those of an index-linked bond because banks generally ask for collateral to be posted on long-term derivatives positions.

“The banks might stretch out to 10 years before they start looking for cash collateral,” he says. “But once you get into cash collateral, the cashflow profile is entirely different, because the company has to have standby credit available to deal with the collateral calls on the swap positions.”

But Beaumont says “the requirement to put in place collateral for any derivatives line varies from bank to bank. We’ve certainly done inflation swap deals without it.”

Greg Mackay, RBS’s London-based global inflation product manager, adds that with a bit of creative thinking, inflation swap deals can be structured without the large back-end payment. “You could do the swap and strip out that back-end payment, which would reduce the credit risk for the investor,” he says. An example would be a real rate swap, where only the coupon, and not the notional at the back end, is linked to inflation.

One utility company that has issued inflation-linked swaps and bonds is ScottishPower. It has £175 million worth of RPI-linked bonds outstanding and £100 million of swaps. Its treasurer, Scotland-based Adrian Coats, says when the utility issued inflation-linked bonds in 2000 and 2001, market conditions were favourable, so he feels he got a good deal. “We found that when we were issuing RPI bonds, demand was such from pension funds that the price we paid in excess of an ordinary conventional bond was very small,” he says.

And he is also happy with the swap deals he did in 2001. “We found when we were issuing that we could quite often get a better price all in by issuing a conventional bond but with an RPI swap attached to it,” he says. It all depends on timing when to enter the market. “There have been periods when people have just been desperate to receive index-linked, so you can get a movement between the conventional markets and the swaps market that’s favourable,” says Coats.

IAS 39
But regardless of market timing, both Coats and Fallon agree that, at the moment, a lot of utility companies are being put off the inflation swaps market because of continuing uncertainty surrounding the new accounting standard, IAS 39, for marking derivatives to market, which is due to come into play next year. There is a fear it could bring volatility to the balance sheet.

Under IAS 39, all derivatives are presumed to be ‘held for trading’ and must be fair-valued with gains and losses recognised in earnings unless they qualify for ‘hedge accounting’, which means that although the derivatives mark-to-market value goes through earnings, the value of the hedged item is adjusted so that its hedged gains or losses also go through earnings. The two values offset each other so that the resulting net earnings impact is zero. The more instruments, or parts of instruments, that a company can qualify for hedge accounting, the less earnings volatility will be an issue.

This obviously affects both issuers of inflation-linked bonds, because they effectively come with embedded derivatives, and direct users of derivatives in the form of inflation swaps. At one point, the utility companies were worried that under IAS 39 they would have to strip out and value the embedded derivatives in their inflation-linked debt. However, as this embedded inflation swap is also a proxy hedge for the interest rate embedded in the bond, it should qualify for hedge accounting. It is the other financing option, of using inflation swaps with a standard bond, that has got utility companies worried.

As IAS 39 currently stands, a utility can issue an index-linked bond and get one type of accounting treatment for it, but if they create the same exposure, albeit synthetically, by issuing a fixed-rate bond and overlaying it with an RPI swap, then the accounting treatment is totally different, and is, in fact, unfavourable in the eyes of the utility.

Fair? “I find it [IAS 39 rules] almost offensive,” complains Coats. “You can have a bond that you don’t have to break out into two pieces, but you can’t have a bond with an RPI swap that gets you to precisely the same result.”

Investment banks say the inflation derivatives market for utilities is definitely taking a battering as a result of IAS 39. “A lot of our clients have told us that until they are confident about achieving hedge accounting under IAS 39, they will not enter into inflation derivatives,” says Karan Bhagat, London-based director of capital markets, European derivatives coverage, at Barclays Capital.

“Gaining synthetic index-linked exposure is cheaper than issuing in the bond markets right now, but clients are struggling to gain the right hedge accounting treatment for it under IAS 39,” says Beaumont. “I find it quite difficult to follow the argument that if I have two economically indifferent instruments then I have to account for them in completely different ways.”

For now, the International Accounting Standard Board (IASB), which is in charge of setting IAS 39, is unrepentant. “The accounting follows the way you do the issuance,” says Sandra Thompson, London-based senior project manager at the IASB. “If you issue in two pieces then you have to account for those two pieces separately, so you can’t package the bond and the inflation-linked swap together as if they had been issued in a single instrument.”

Thompson adds, however, that the IASB is ready to consider new viewpoints. “I haven’t had any comments on this from utility companies, but if they want to come and talk to us I’m very happy to listen to what they have to say.”

Investment bankers are confident that once uncertainty surrounding IAS 39 is cleared up, utilities will once again return to the inflation derivatives market. They have good reason to be optimistic. “Volumes in the inflation derivatives market are growing at a quite phenomenal rate – at the moment probably doubling less than annually,” says Joe Mulvey, European inflation derivatives trader at Barclays Capital in London.

With that kind of demand, utilities will surely once again open up to this market.

Rough guide to inflation derivatives for utilities

The inflation derivatives market owes its existence to the inflation bond market. In the UK, the inflation bond market has been in existence since 1981 – around 25% of UK government debt is inflation-linked. Governments, but also companies with revenue streams linked to inflation, issue inflation-linked debt. The supermarket chain Tesco, for example, has issued index-linked bonds, because the goods that it sells virtually comprise the RPI basket. This is an example of an indirect link to inflation, but when we look at utilities we find their income is linked directly to inflation. The monopolistic nature of the utility business means regulators are called on to decide how much utilities should charge their customers. In the UK, prices are effectively set every five years by the various regulators in each industry. These prices are directly linked to inflation, and that means that inflation-linked financing – if it can be achieved at the right price – makes sense for utilities. But inflation-linked bonds are idiosyncratic. Unlike a standard bond, which requires the repayment of a fixed nominal amount when the debt matures, the amount to be paid back on an inflation-linked bond rises with inflation, while the coupon payments start at a relatively low level and also rise with inflation. That means the income stream on this type of debt is ‘back-ended’, and that the duration of an index-linked investment is longer than its standard counterpart, even if the legal maturities are the same. From index-linked bond prices it is possible to extract future market expectations of inflation, and therefore price inflation derivatives. With an inflation swap, a utility commits to receiving either fixed payments or Libor from its counterparty bank while paying in return a stream of index-linked cashflows. Combine this with the issuance of conventional bonds and, economically at least, a utility company is in the same position as if it had issued index-linked debt.