Fixed rate takes stress
If you own real-estate leases in which the rent is linked to inflation, the UK pension fund industry wants your number. A shortage of other sources of inflation-linked income has left funds struggling to comply with the 2004 Pensions Act, which requires the industry to inflation-proof its pensions – and real-estate developers are increasingly taking advantage. In some cases, large pension funds have bought property outright, purely to gain exposure to real income (in other words, income streams which at least match the rate of inflation) but it is more common for banks to act as match-makers: sourcing inflation from the real-estate sector, and passing the income to funds through swap transactions. The need is so severe that developers are in a strong position to negotiate better rates, bankers admit.
"There’s real competition among banks to find business of this kind," says David Slater, head of inflation trading for the UK with BNP Paribas in London "That competition really appeared in 2005 after a big increase in demand from funds wishing to cover their inflation-linked liabilities with inflation-bearing assets – banks pushed their real-estate finance teams to go out and uncover more inflation-linked leases. That kind of activity is intensifying again."
The 50-year UK linker currently pays around 80 basis points plus the rate of inflation, says Evan Guppy, a manager in the inflation structuring team with HSBC in London: "For many pension funds, those levels are not enticing enough to invest in inflation-linked products."
Banks have also sourced inflation in other sectors of the economy: public utilities have revenue streams which are linked to inflation, as do private finance projects in which local government authorities provide the project company with an inflation-linked annuity. In both cases, banks courted these clients in order to satisfy pension fund demand, but this has now hit the buffers. Private finance transactions have been scarce, say bankers, while getting inflation out of the utility sector was only possible via a long, fragile chain of transactions which has crumbled due to the sub-prime crisis: utilities issued inflation-linked bonds which typically achieved triple-A ratings thanks to guarantees provided by monoline insurers, and investors would then swap out the inflation exposure, leaving them holding a secure asset earning a decent fixed return and allowing banks to pass the inflation income on to pension funds. But the threat of rating downgrades to the monolines has made investors wary, says one London-based inflation trader: "There are concerns that the guarantees aren’t worth the paper they’re written on, so we’ve been having trouble finding people who want to buy the underlying bonds."
No bond sales means no inflation swaps – and that means unhappy pension funds, so banks and their fund clients are training their beady eyes on the real-estate industry, where around 10% of outstanding leases are linked to inflation, according to BNP Paribas’ Slater, and inflation-indexing is becoming a more common feature of new lease contracts. This is no bad thing for developers – banks argue that swapping inflation-linked for fixed income over the life of a 20 or 30-year lease is a smart move, and is something, which developers should be doing regardless of sating the pension fund industry driven demand.
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"It’s about taking advantage of the value of income certainty"
Christian Alibert, RBS |
"The real-estate sector is a key stakeholder in the inflation business and, as such, it has a degree of power. Banks need their supply just as much as real-estate clients need to hedge. It’s not necessarily what you’d call a seller’s market, but real-estate clients are learning that, in some cases, circumstances definitely favour them," says Christian Alibert, co-head of inflation trading with RBS Global Banking & Markets in London. He says that the bank did its first hedge of an inflation-linked real-estate lease around 2001 and then two or three annually until the market’s watershed year in 2005 – RBS now does around 10 trades each year.
So, how does the inflation market work from a developer’s point of view? In essence, it’s pretty simple. The developer owns a lease, which generates rental income, which increases in line with inflation. In a swap transaction, the developer agrees to pass the rental income to a bank, in return for fixed income over the lease’s life. The benefits for developers are two-fold – rather than being prey to the vagaries of inflation, they are certain of the lease’s worth, which allows them to construct more robust business plans and potential sweeter financing terms.
"It’s not simply about getting rid of income uncertainty. It’s about taking advantage of the value of income certainty," says RBS’ Alibert. He sketches out an example in which a developer has a 20-year lease with an income of £1 million a year, and goes to a bank looking for a loan, using the income from the lease as collateral: "If you tell a bank that you’re receiving an inflation linked income for the next 20 years, they’re not going to put much value on the inflation component – for all they know, we might be in a deflationary environment for the next 20 years. However, if you swap the inflation income prior to going to the bank, you can tell them that you’ve got a fixed rate for the life of the lease." By compounding over 20 years the kind of rates available at the moment, Alibert says that today’s £1 million of rental income would double by term date. The history of the UK’s RPI inflation index shows that allowing inflation-linked income to compound over the last 20 years would have produced the same doubling effect (see graph), but Alibert points out that swapping the inflation income for a fixed rate removes any uncertainty.