Looking for inflation hedges, investors buy structured products linked to Consumer Price Index

By Emma Trincal

New York, June 8 - With investors bracing for more inflation, agents are increasingly bringing to market notes linked to the Consumer Price Index, data compiled by Prospect News shows. Some recently priced deals reveal that those products can be well bid.

"People anticipate more inflation and a rise in interest rates, so it makes sense," said a sellsider.

"Right now, the only products that consistently work are commodities and rates," he added, pointing to the fact that both asset classes are often used as inflation hedges.

Several deals

Citigroup Funding Inc. plans to price this month non-callable notes due June 20, 2021 linked to the index, according to a 424B2 filing with the Securities and Exchange Commission.

The coupon will be 5% for the first year. After that, it will be equal to the year-over-year change in the CPI plus 150 basis points, up to a maximum rate of 7%.

Separately, UBS AG, Jersey Branch will price fixed-to-floating-rate notes due June 29, 2021 linked to the CPI, according to an FWP filing with the SEC. The coupon will be 4% for the first year. After that, the rate will be equal to the year-over-year change in the CPI plus 115 bps, subject to a maximum rate of 7%.

The volume of CPI-linked note issuance rose by 29% to $245 million for the second quarter through June 7, compared with $190 million during the same period in the first quarter, according to data compiled by Prospect News.

The number of deals also jumped to 15 from nine, and their percentage of total volume doubled to 2.77%.

Recently priced

The size of some recently priced deals indicates that investors have appetite for those products, which offer another selling point: they guarantee principal back at maturity subject to the issuer's credit risk.

On May 25, for instance, JPMorgan Chase & Co. priced $26 million of fixed-to-floating notes due May 31, 2021 linked to the CPI, according to a 424B2 filing with the SEC. The coupon is 4.25% for the first year. After that, the rate will be the year-over-year change in the CPI plus 150 bps, subject to a maximum rate of 7%.

On the same day, Wells Fargo & Co. priced $15 million of fixed-to-floating notes due May 28, 2021 linked to the CPI, according to a 424B2 filing with the SEC. The fixed-rate interest rate is less at 3.5% but lasts for the first two years. After that, it will equal the year-over-year change in the index plus 125 bps, subject to a maximum rate of 6.75%.

On June 1, Morgan Stanley priced $7.71 million of fixed-to-floating notes due June 9, 2023 linked to the CPI, according to a 424B2 filing with the SEC. The coupon is 6.25% for the first year. After that, the notes pay a 200 basis spread over the CPI change, subject to a maximum rate of 8%.

Moving parts

The sellsider said that those deals had several moving parts.

Longer durations usually make for better terms. That is the case with the 12-year Morgan Stanley deal, which gives investors both a higher initial coupon and more spread over the CPI, he noted.

"Problem with these rates deals is that they're extra long in duration. People agree to those terms because rates are so low in the U.S. The shorter the term, the smaller the coupon. So investors have to go longer," he said.

The deals also differ in the amount of fixed-rate coupon offered by the issuer, typically for one year only but sometimes for more, like the Wells Fargo deal, which grants a fixed rate for the first two years.

Another important term, the sellsider said - in fact, the most important among all of them, he added - is the amount of spread over the year-over-year change in the CPI.

"You shouldn't really care about the first year's rate. It's a hook. It's just a teaser. What's really important is the spread over the CPI. That's what is going to give you some return over time, if inflation goes up," he said.

Another structural feature is the cap on the interest, almost always there, he said.

"It cost a fortune for the banks to structure those products. If inflation does go up, they'll have to keep on paying more. That's why they have to cap. It's unavoidable," the sellsider said.

Deflation fears

Not every investor or adviser is comfortable with these products though.

Some believe that the real threat short term is not inflation but rather a sluggish economy with prices that may be kept on hold for some time.

"We tend to stay away from these CPI deals because we don't think inflation will be a big issue. I'd much rather play rates than inflation," said Thomas Livingston, director of structured products at Halliday Financial Group.

"The Fed is going to have to tighten to finance the U.S.' massive deficit. But inflation will be short-lived because the economy is slowing.

"You may have inflation over time, but no one knows when. There won't be a real inflation problem until you get wage pressure. And with 14 million unemployed people, I don't think we have to worry too much about inflation."

© 2015 Prospect News.
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