Inflation-linked swaps with regulated UK utility companies and PFI projects

“When the seller is ready, a buyer will appear.”

Even in today’s negative real yield environment, demand from pension schemes for inflation-linked assets remains strong.  Because they offer liability matching characteristics, pension schemes, for risk management purposes, have continued to pay, what they and their historical models, would consider to be expensive prices for inflation-linked assets.  While most pension funds access their exposure to inflation-linked assets through either their LDI or gilt managers, some are also beginning to consider opportunities beyond the index-linked gilt and collateralised swap markets, especially if there are attractive yields on offer.

One opportunity that has arisen over the past year is that in response to tighter capital standards, banks are increasingly looking to reduce the uncollateralised derivative counterparty credit exposures that they have on their books.  At first blush, it may not seem that these kinds of exposures would be attractive to pension schemes, but they can include perfectly good assets, such as inflation-linked swaps with regulated UK utility companies and PFI projects.  Utility and PFI swaps typically deliver long dated inflation-linked cash flows with additional compensation for the credit risk of facing a utility company or PFI project on an uncollateralised basis.  For this reason, they can offer pension schemes good liability matching characteristics and depending on the terms, attractive compensation for the credit risk and illiquidity of the exposure (often well in excess of the spread on the issuer’s comparable bond).  In fact, a small handful of Canadian pension funds, often as part of a consortium with private equity and other infrastructure investors, have invested in the equity part of the capital structure of UK utilities already, recognising the attractiveness of the cash flows that these businesses generate compared to pension liabilities.

When assessing these kinds of swaps and their suitability for a particular pension portfolio, understanding their background is helpful. The main source of inflation supply in the UK is the index-linked gilt market; while the gilt linker market is approximately £280 billion in size, it is not the only source of inflation supply in the UK markets.  Regulated utility companies and PFI projects are also important sources. These entities tend to have revenue streams contractually linked to RPI and, as such, are predisposed to issuing inflation-linked bonds within their overall capital structures.  The corporate linker market, however, is relatively small at around £32 billion and much less liquid than the gilt market.  For this reason, utility companies and PFI projects were historically able to achieve lower all-in financing rates by using alternatives to issuing inflation-linked bonds outright, either by taking out bank loans or by issuing conventional bonds in conjunction with entering into inflation-linked swaps with banks (such that the loan and/or conventional bond plus inflation-linked swap would be an equivalent exposure to an inflation-linked bond).  While banks used the inflation supply that the swaps created to support their LDI businesses (ie, sold the inflation supply to pension schemes, usually under gold standard CSA’s), the cost to the banks of holding these utility and PFI swaps is increasing with the move to Basel III and this is what is now pushing them to look for opportunities to sell these exposures to suitable investors, particularly pension funds.

Below is a table corporate index-linked bond issuers (click to enlarge).

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Because the swaps effectively combine LDI with credit research, it often takes some bespoke work to ensure that they can be supported by a pension scheme’s LDI or credit manager.  As part of the due diligence, a number of practical issues must be considered: the swaps’ cash flow profile, credit risk and seniority, collateral terms, counterparty rating requirements, and any break clauses or other credit risk mitigants that may be included in the documentation. But the overriding consideration is the price at which banks are prepared to sell these exposures. As banks transition to Basel III, it is not surprising that they are more willing to offer these assets at more attractive prices than they would have previously, and indeed a few transactions have already completed over the past year at very attractive levels.

With interest rates remaining stubbornly low and banks continuing to count the cost of tighter capital requirements, pension schemes can benefit from new opportunities such as this and step into a space historically occupied by banks alone.  These opportunities will exist not only for past transactions already on banks’ books but also increasingly for new transactions going forward.  It is a space worth watching.

The following table offers a summary comparison of these swaps to traditional inflation-linked assets held by pension schemes (click to enlarge).

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