The £49bn (€67bn) Universities Superannuation Scheme (USS) has become a direct counterparty to a UK utility company in an inflation swap used to manage liabilities.
Inflation swap derivatives are normally run through banks that act as counterparties to both sides.
The cost of managing these transactions, however, has increased due to banking regulation since the financial crisis.
The deal with Yorkshire Water, thought to be worth more than £130m, was arranged when the company’s previous swap deals approached a break clause – where banks and customers often renegotiate the pricing of derivatives.
The multi-employer pension scheme for higher education workers in the UK said long-dated derivatives were becoming expensive for counterparties to roll over with banks when break clauses are reached.
Yorkshire Water’s break allowed USS to offer an alternative, adding an inflation match in the scheme’s liability-driven investment (LDI) portfolio.
Ben Levenstein, head of private debt and special situations at USS Investment Management, the scheme’s in-house asset manager, said it restructured Yorkshire Water’s inflation swap to match its own requirements.
“We got to a situation where both parties were happy with the predicted stream of cash flows from the new swap put in place,” he said.
USS, which has 7.4% of its assets in LDI, purchased long-dated inflation swaps from Yorkshire Water that mature in 2063.
It also removed any further break clauses.
Levenstein said USS began discussions with the water company a year ago, knowing it would require inflation-linked financing.
Water companies in the UK are owned privately, but their revenues are regulated by the government and include annual adjustments in line with the retail prices index, the same inflation measure used by USS to increase pensions.
He said the scheme was keen to continue sourcing direct inflation-swap deals with companies that require counterparties with a longer-term perspective.
“We are very keen to explore new opportunities,” he said. “USS is perfectly suited to this sort of investment with inflation and duration exposure.
“There have not been many of these transactions before, so we have developed the process to undertake ones like this.”
USS declined to comment on the structure of the deal, including whether the swap was collateralised.
Levenstein, however, said Yorkshire Water was a “strong” counterparty.
The pair set up a special-purpose vehicle, Aysgarth Finance, to manage the swap’s cashflows.
Earlier this year, Yorkshire Water announced it held £2bn in inflation swaps, with further breaks in 2018, 2020, 2023 and 2025 but plans in place to manage the breaks in 2018.
Yorkshire Water said its inflation-linked derivatives portfolio was putting pressure on the company’s credit quality, downgraded recently by Moody’s.