Inflation derivatives house of the year: HSBC

For years now, bonds and swaps linked to the UK’s consumer price index (CPI) have been the next big thing in inflation markets. On September 4, they were condemned to wear that tag for at least another five years.

While users of the flawed retail price index (RPI) transition away from it, the UK’s chancellor of the exchequer said the move to CPI – recommended by the UK’s statistics watchdog – would have to wait.

For companies that either have – or will soon need to have – CPI exposure (notably water and power utilities), this leaves them needing to manage this risk in a deeply illiquid market. This year, in a series of landmark transactions, HSBC applied lessons it had learnt from its years at the forefront of the RPI market to help develop the fledgling product.

“The UK CPI market has moved from a nascent early stage well into what I’d call the intermediate stage,” says Dariush Mirfendereski, global head of inflation trading at HSBC. “By bringing to market these transactions, and appropriately pricing, hedging and distributing the supply, we’re actually dealing with a very similar journey that the RPI market went through in the early 2000s before reaching maturity.”

Most prominently, the bank took a leading role in a CPI inflation repack transaction with Anglian Water – the first time this structure had been used for CPI. The utility had a £250 million, 28-year pay-fixed, receive-floating interest rate swap position in place, but was paying a high off-market rate and wanted to cheapen the position by trading a CPI swap overlay.

The trade would see Anglian pay CPI to HSBC and receive the same high fixed rate as the interest rate swap. With the two fixed legs cancelling each other out, Anglian was effectively paying CPI and receiving a floating Libor rate.

To reduce the credit and funding costs that occur in long-dated, uncollateralised swaps, a repack structure made sense, where the inflation accretion payments are essentially routed to alternative investors via a special-purpose vehicle (SPV).

Investors pointed Anglian to the novel repack structure HSBC pioneered with Yorkshire Water last year. This allows the deal to avoid an SPV, and instead channel payments through HSBC Bank Plc, which has a AA– long-term rating from Standard & Poor’s (S&P). As Anglian is a whole business securitisation, it can’t face an unrated SPV without amending its documentation, so this structure avoided this long and drawn-out legal process.

As CPI is illiquid, it is priced as a spread below RPI – the gap between the two is known as the wedge. The transaction took a few months from start to finish, meaning there was lots of time for the wedge to move around.

The UK CPI market has moved from a nascent early stage well into what I’d call the intermediate stage

Dariush Mirfendereski, HSBC

Anglian was concerned about this, so HSBC decided to fix the wedge for around three months to help them get comfortable with the trade.

“Like with any bifurcation, it takes a bit of time – particularly as it’s the first time we’ve done one linked to CPI – so there were additional steps we needed to run through and get comfortable on. It took a few months, and that’s a long time for the price to be moving around,” says Will Higbee, co-head of corporate risk solutions for Europe, the Middle East and Africa at HSBC.

Of the £300 million ($385.3 million) of CPI swaps Anglian needed to get done, £200 million was done with HSBC.

Less structured – but no less important – was the trade with United Utilities. The largest publicly listed water company in the UK has a sophisticated treasury that issues RPI and CPI bonds, but had never dabbled in the swap market.

The UK water regulator is pushing for utilities to increase exposure to CPI-H – CPI that includes housing costs – but there is no market for trades directly against that benchmark, so CPI is seen as the next best thing. HSBC saw an opportunity to pitch a trade in which the company would take existing RPI bonds and overlay an RPI-versus-CPI wedge trade over the top to synthetically convert them into CPI debt.

After more than a year of discussions, the company agreed to do the trade over three RPI bonds, with a collective notional of around £100 million, and expiries between 10 and 20 years. The wedge in the bond market can differ from the swap market, and at this time synthetically converting RPI bonds to CPI would result in a better deal than issuing new CPI debt.

One problem was the timing – it was near the start of 2019 when discussions around RPI reform were at their peak. This uncertainty meant liquidity for wedge trades was thin, and HSBC would have to warehouse the position over a potentially volatile period. Nevertheless, the UK bank’s pricing won out.

“The driver of the RPI/CPI basis trade is the level of the wedge and the credit and funding fees. We were speaking to a small number of banks about a similar trade, and it came down to who had the best wedge and fees. Some had a tight wedge but wider fees, and vice versa. HSBC had the best combination,” says Rachael Wray, assistant treasurer at United Utilities.

A third big CPI deal was transacted with power station operator Drax. The biomass specialist needed £250 million of seven-year CPI swaps to hedge its CPI-linked revenues, eventually executing 80% of the trade with HSBC.  

Away from CPI, the bank’s willingness to underwrite large swap risks helped one large inflation-linked deal get over the line in the last year.

The first was a large refinancing and inflation swap extension for the M25 road project in the UK. The project finance company wanted to refinance its nearly £900 million of debt, and extend it by two years to 2039. HSBC offered to underwrite the new bond issuance, and backstopped the credit spread.

The client also had inflation swaps with 12 different counterparties linked to the debt that needed to be extended to the new maturity. With S&P concerned about swap counterparty ratings, Barclays, HSBC and Lloyds were given one-third each of the newly extended RPI revenue-style swaps, at a total size of £30 million a year.

The swaps were heavily out-of-the-money for the client, though, and that mark-to-market was to remain in the swap. So, just in case any of the 12 banks shied away from the deal, HSBC agreed to take on all the other positions if needed.

We were holding the risk to ourselves, and then we distributed it later. That’s a complication that is not often seen in the regulated utility space

Prabhudutta Kar, HSBC

While the guarantees and backstop were not needed in the end, it helped the project finance company get comfortable enough to progress with the transaction.

HSBC then used its repack solution to distribute its portion of the risk to investors, representing the first time the structure has been used in the market outside the regulated utility space. With the timing of project finance bonds uncertain, it wasn’t possible to organise the repack element to coincide with the refinancing and swap restructuring.

The HSBC team obtained internal permission to hold the risk on its books for several months, but in the end, only needed a few days.

“We were holding the risk to ourselves, and then we distributed it later. That’s a complication that is not often seen in the regulated utility space,” says Prabhudutta Kar, a director in fixed income structuring at HSBC.

The client was pleased with the result. “They kept things simple by doing the repack behind the scenes. It made the transaction far more deliverable by avoiding any complications,” says Stephen Worthy, transaction lead for Connect Plus, the joint venture behind the project.

Elsewhere, the bank has successfully stayed on top of its own LCH bilateral exposure, which hasn’t been easy, given its large corporate client base.

The basis emerged because of a structural imbalance in the inflation market – corporates tend to sell inflation bilaterally, while pension funds and insurers are net buyers in the clearing house. These positions don’t offset, leaving dealers with a directional position in LCH that attracts initial margin.

Pension funds have recently been either unwinding their old short bilateral positions to move into gilts, or backloading them to LCH – both of which increase initial margin and push the basis wider.

One key lever to manage this is the basis itself – if a dealer can offer a better rate to clients such as pension funds to trade bilaterally, reducing the dealer’s basis exposure, then everyone wins. As a result, HSBC has managed to maintain a flat to positive exposure to the basis.

“The LCH bilateral basis in the long end is quite wide, at nearly seven basis points at the 50-year point. At these levels, bilateral RPI swaps start looking attractive versus LCH for some clients,” says Udit Kapoor, a liability-driven investment salesperson at HSBC.