Inflation seller: Øresund Bridge
While pension funds, insurers and private investors benefit from lower inflation, public authorities and enterprises, utilities, real estate and distribution companies profit from higher inflation. So, the latter group can benefit from becoming inflation sellers, according to a Fortis Investments reports, ‘Inflation swaps to safeguard future income or hedge against future obligations’.
“By selling inflation in an inflation-linked swap, they are able to protect future income linked to inflation,” it says.
One such inflation seller is Øresundsbro Konsortiet, the Danish-Swedish company that is responsible for the operation of the Øresund Bridge that links the Danish capital Copenhagen and the Swedish city of Malmö.
“Because we are a toll-financed infrastructure project, our income is very highly correlated with inflation,” says Øresundsbro Konsortiet finance director Kaj Holm. “High implied inflation - the premium that investors pay - is good for us, as it means that we have a good cushion against outer inflation developments. And that is why we are an obvious participant in the market.”
Øresundsbro Konsortiet started selling inflation in 2003. By issuing inflation-linked loans and swaps it changed its debt structure from traditional nominal to inflation-linked debt. Today approximately 25% of its total debt exposure is inflation linked, says Holm.
“We see this as a major way of reducing the total financial risk of the project over the long term, as we expect to be in the market for at least 30 years,” Holm adds. “And from a strategic point of view it does not matter whether we issue inflation-linked debt or swaps; it is merely a pricing issue on the day you do the transaction. In general, inflation-linked debt is slightly more expensive than traditional nominal debt, in particular when linked to the Danish price index, which is more illiquid than the euro market. However, this disadvantage is outweighed by obtaining the strategic risk management advantage through debt that is exposed to inflation.”
AAA-rated Øresundsbro Konsortiet’s debut into selling inflation came as markets - and real euro rates - fell sharply between 2000 and 2004 and implied inflation was volatile. Since reaching its risk analysis-based goal of 25% inflation-linked debt exposure in late 2004, the company has not been active in the market.
“At that time we more or less created our own variations of the products because we were issuing debt and selling inflation swaps denominated in euros but based on the index for Danish inflation,” says Holm. “For us it meant that we were able to reach a broader investment base, as several potential investors were interested in euro-denominated bonds and swaps, while we were able to make use of the actual Danish price index, to which our toll rates are exposed. From a risk management point of view this was important and consequently we increased our exposure to 25%. At the same time, we also restructured some old inflation-linked exposure, such as the French OAT inflation, into Danish inflation. We had to create the benchmark trades in Danish inflation ourselves as the Danish government - unlike the Swedish, which has a government inflation-linked market and pricing benchmarks - does not issue inflation linkers.”
A number of banks scrutinise the market for Øresundsbro Konsortiet, speak to investors on the company’s behalf and rate the swaps. “It is an interactive process with the market participants,” says Holm. “The number of investors and inflation buyers has been increasing rapidly over the last few years, which has created a more liquid market for us.”
But what has been the effect of the current market volatility? “Implied inflation has been picking up since the credit crisis started last summer and investors have been trying to protect themselves against inflation risk by investing in inflation-linkers,” he says. “And if they trade with highly credit-rated entities, they have no credit or inflation risk.”
According to Holm, their first inflation buyers were large European pension funds - including Dutch and French pension vehicles - that already had inflation portfolios with exposures to the euro Harmonised Index of Consumer Prices (HICP), French OAT and French HICP and were looking for exposure to Danish inflation. It was only later that Øresundsbro Konsortiet also attracted interest from Danish pension funds.
Holm has noticed increasing demand for the inflation-linked debt and different inflation swaps. “We have seen interest for different swap structures from zero coupon to OAT structures,” he says. “But we are flexible and whether we sell inflation in one way or another is not an issue for us.”
Øresundsbro Konsortiet is to review its debt exposure distribution between nominal and inflation-linked debt over the coming months.
“The transactions that we made a few years ago were for 15 years and more, and our inflation-linked debt is increasing year by year on a relative basis, since our total debt is falling” says Holm. “It is still uncertain whether we will continue to sell inflation in the future. We may increase our inflation-linked exposure from a strategic point of view but that is still to be decided.”