Themes: Inflation / Risks / Hedging instruments

When projects are exposed to inflation, whether through costs (labour, wages, construction costs, etc.), or through income (indexation of electricity sale contracts or rent, etc.), hedging against exposure to inflation can secure the investor’s IRR.

Hedging against inflation's exposure can secure the investor's IRR

Before a decision can be made as to the advisability or feasibility of hedging against inflation risk, several questions must be answered:

• What is the source of exposure on the asset and liability sides, what are the inflation indices involved, to what extent do cost inflation and income inflation offset one another, and what is the ultimate net exposure?

• How variable are the base amounts concerned (on the income side and cost side)?

• Is it possible to hedge this net exposure using market instruments?

Projects' exposure to inflation

1. Where does a projects' exposure to inflation come from?

Projects can be exposed to inflation:

• Either explicitly, when the contracts determining income or costs are explicitly tied to a goods or services price index (such as the consumer price index, CPI), a rent index (such as the rent reference index, IRL), or a cost index (such as the construction cost index).

• Or implicitly, if an increase in these prices is likely to have an impact on the conditions under which the company will be able to buy the goods and services necessary for production, or conversely it will probably be able to adjust its sale prices to take account of changing prices in its sector of activity.

Some public private partnerships tariffs or Corporate PPA tariffs are linked to changing consumer prices. On the other hand, the reference indices used in other sectors and/or for costs are more often specific indices linked to the sector of activity or to necessary production goods (raw materials, etc.).

2. The concept of net exposure

The company is exposed to a rise or fall in inflation if its costs are not indexed in the same way as its income, for example if income is fixed by a long-term contract without any indexation, but purchasing prices or salaries are under strong pressure.

Inflation risk management is generally a matter of reducing net exposure

Inflation risk management is generally a matter of reducing net exposure.

If indexation is confined to income or to costs, it may be useful either to restore natural hedging between costs and income by renegotiating contracts, or to hedge against the exposure arising from costs or income.

If the indexation of costs and income is correlated but not identical, the quality of natural hedge must be examined to determine whether it can play a real role in mitigating risks – or whether it could actually create new risks. If the indexation of costs and income involves similar price indices on similar base amounts, natural hedge may be effective. However, if either the indices or the base amounts are very different, it may prove insufficient.

The situation where income is indexed to inflation and debt is exposed to a variable rate should also be mentioned. While it can be shown statistically that there is often a close correlation between short-term rates and inflation when the central bank has a mandate to control inflation, this correlation does not always ensure good natural hedge. It is therefore essential to carry out further analysis to establish with as much certainty as possible whether part of the debt can be left at a variable rate in this case.

Finally, before any decision is made, the net exposure and the variability of income and costs should be considered carefully. Using market instruments to hedge income that is explicitly indexed when:

• Costs were providing partial natural hedging and/or

• Income is uncertain (e.g. tolls for a motorway to be constructed)

may lead to an increase in inflation risk rather than a decrease.

Several types of inflation-indexed instruments are traded on the financial markets: bonds, swaps and, to a more limited extent, options.

Bear in mind, though, that these instruments are all linked to a few mainstream indices, which are unlikely to reflect the company’s exposure accurately. If a company plans to hedge its inflation exposure, it is therefore crucial to have negotiated in its various contracts, an indexation using hedgeable indices, or indices which are close to hedgeable indices.

If a company plans to hedge its inflation exposure, it is (…) crucial to have negotiated in its various contracts, an indexation using hedgeable indices, or indices which are close to hedgeable indices

The market for inflation-indexed financial instruments

1. Inflation-linked bonds : historical background

The first inflation-linked bonds were issued by the Commonwealth of Massachusetts in 1780 during the War of Independence.

In the 1980s, the UK was the first major developed country to introduce ‘linkers’ on the market.

In January 1997, the United States began issuing TIPS (Treasury Inflation-Protected Securities), which today are the most important component of the international ILB market.

In 1998, France was the first country in the Euro zone to issue inflation-linked treasury bonds based on French inflation, excluding tobacco (OATi); these were followed by OAT€i, indexed to European inflation excluding tobacco.

Germany, Greece (occasionally) and Italy subsequently also issued bonds linked to European inflation, excluding tobacco.

2. Inflation swaps

The first inflation swap markets developed in regions where there was an active market for inflation-linked bonds.

With an investment bank acting as an intermediary, parties needing to receive inflation (pension funds, asset managers, etc.) could be linked up with parties willing to pay inflation (governments or some corporates).

Inflation swaps are of course linked to the same indices as government bonds on the corresponding market. In the euro zone, there are therefore swaps indexed to French consumer price inflation excluding tobacco, and swaps indexed to European consumer price inflation excluding tobacco. In the USA, there are swaps indexed to the CPI; in the UK, the main index used to be the RPI, but a transition is currently taking place towards the CPI.

Conversely, there are regions or countries such as Switzerland or Poland where there is no properly developed inflation market.

Note that even in markets where inflation is relatively liquid, the inflation swap market is significantly less liquid than the interest rate swap market, moreover liquidity has decreased significantly since the 2008 crisis. As a result, the bid-ask spreads are greater there.

Note that even in markets where inflation is relatively liquid, the inflation swap market is significantly less liquid than the interest rate swap market

3. The inflation options market

The markets for inflation options, in the form of inflation caps or swaptions, are even less developed than the inflation swap markets. However, there are a number of markets where it is possible to trade options, for example in Europe, the USA or the UK. Due to lower liquidity, market information on implied volatilities is not easily accessible and transaction costs can be high.

Conclusion

The first step before any inflation hedging is to understand and measure exposure and define the underlying indices and the possible offsetting effects between different forms of indexation.

This may lead to the search for a natural hedge, for example by renegotiating contracts and accepting a certain degree of exposure to variable interest rates, or to the search for hedging instruments.

In the second case, the company must then determine which inflation instruments it should use, and what their volume should be. This may be far from obvious, as inflation exposure is often cumulative.

The final step is to sound potential counterparties to understand their proposals and their capacities.