The U.S. Inflation swaps market is relatively young, having only begun to trade in meaningful amounts in late 2003. While many products have developed in this short time-frame, the two basic forms that still command the vast majority of the volumes are zero-coupon swaps and TIPS asset swaps. Zero-Coupon Swaps Initially, the U.S. Consumer Price Index swaps market was dominated by zero-coupon inflation swaps, similar to the major European inflation swaps markets. In a zero-coupon swap, the flows are very simple. One party pays a fixed rate on a given notional amount, compounded annually and paid in a single payment at the maturity of the swap. The counterparty--or inflation payer-pays the aggregate percentage rise in non-seasonally adjusted CPI. So, for example, in a USD10 million five-year zero-coupon swap the fixed payer might pay 2.5% versus receiving inflation.
The flows would be:
Pay [(1.025)5-1]*10mm
Receive [NSACPIin 5 yrs / NSACPItoday 1] * 10mm
The fixed-rate payer wins if compounded inflation is above 2.5% and loses if it is less than 2.5%. This fixed rate is the rate quoted in the market, so the market for five-year zero-coupon swaps might be 2.50% to 2.52%.
TIPS Asset Swaps
A Treasury Inflation-Protected Security asset swap will seem familiar to many observers of the LIBOR market. One party in this trade buys the asset from the counterparty--in this case, the asset is a particular TIPS bond--and pays all flows of the bond to the counterparty while receiving floating LIBOR minus a fixed spread, quarterly, for the life of the bond. Note that the flows of the bond in the case of TIPS include the inflation uplift at the maturity of the bond. In the U.S. inflation market, asset swaps are done proceeds-neutral, meaning that the LIBOR-side notional is set equal at trade inception to the full price of the bond. The asset swap is meant to simulate a buy-and-hold-and-finance strategy, and what is quoted in the market is the funding leg. For example, an asset swap buyer might bid LIBOR minus 18 basis points for the TII 07/13 asset swap versus a LIBOR minus 20 basis points offer.
TIPS Swaps Pros And Cons
One complexity that arises with TIPS asset swaps that one does not encounter in asset swaps of normal Treasuries is that the notional amount of the LIBOR side of the swap is fixed, but the TIPS bond of course grows in value over time with inflation. This means that, over time, the receiver of TIPS flows--the seller of the asset swap in market parlance--almost always develops credit exposure to the payer of TIPS flows. While many counterparties in today's market enjoy full collateralization, some do not and this may have implications for pricing. But, as with conventional Treasury asset swaps, the predominant determinant of asset swap levels is the cost of funding the physical TIPS position. Since TIPS to date almost always can be financed at general collateral rates, asset swap spreads tend to be lower than Treasury asset swap spreads, floored around LIBOR minus 10 to LIBOR minus 15, and comparatively stable.
When the U.S. CPI swaps market started in 2003, asset swaps were not on the interbank menu. The structure was very popular with hedge funds, however. As a result, in 2004 asset swaps began to trade in the interbank market off the back of those hedge fund flows.
Zero-Coupon Swaps Pros And Cons
The advantages of the zero-coupon inflation swap structure are its simplicity, the elemental nature of the bet on inflation, and its usefulness for curve construction. The disadvantages lie in the execution of the instrument. Similarly to TIPS breakeven inflation rates--the difference between Treasury and TIPS yields--zero-coupon inflation swaps can be somewhat volatile. Since many market participants care more about the basis between the swap flows and the TIPS breakeven inflation rate, a buyer of zero-coupon swaps often needs to execute a hedge in TIPS breakeven inflation and this limits the size of trade that can be done. In the LIBOR market, to show the contrast, swaps of USD500 million are not uncommon since dealers virtually always exchange the Treasury hedge; if the LIBOR market traded on rate rather than on spread, it would be much less liquid. The second disadvantage of zero-coupon swaps is tied to seasonality. While a spot zero-coupon swap has scant exposure to the seasonal pattern of inflation since it is quoted in round numbers of years, a seasoned zero-coupon swap will have some exposure to seasonal patterns except for the one day out of the year when it happens to have a whole number of years remaining to maturity. While this can be a problem for clients who want to unwind an existing trade, the market is becoming more efficient at pricing for seasonality and the re-launch of CPI futures in early 2007 should lessen this disadvantage.
TIPS Versus Zero-Coupon Swaps
The advantages of the TIPS asset swap structure are its familiarity and its stability, although as noted previously that familiarity is somewhat illusory since the underlying asset is dissimilar in some ways to Treasuries. TIPS asset-swaps can be more liquid, at least in principle, since the nature of the trade is that the asset is exchanged for the asset's flows. But there are some big problems with the asset swap structure, too. While unwinding an asset swap can be easier than unwinding a zero-coupon trade since the structure is quoted in the market, this is not the same as saying that seasonality is not a problem with the asset swap structure. Quite the contrary: except for one day out of the year, an asset swap has seasonality issues as well. The apparent stasis of asset swap spreads reflects market participants' belief that the TIPS market fully accounts for known seasonal biases. Even if this were the case, however, a major impediment to the market-standard aspirations of asset-swap devotees is that creating a swap curve--the sort that can be used to price other derivatives or new issues of inflation-linked bonds--from asset swaps forces one to back out seasonality that may or may not be accounted for in the bonds themselves. Consider analogously the problems that would be encountered if one tried to create a LIBOR curve, given only the asset swap levels of all of the Treasury bonds extant. The idiosyncrasies of the bonds would make that task well-nigh impossible.
Moreover, a TIPS asset swap trade is not precisely a bet on inflation. The asset being exchanged is not based on inflation, but pays a real rate and its value fluctuates based on changes in real rates. The asset swap stripped of the hedge exchange involves a bet on real rates, with incidental bets on TIPS bond idiosyncrasies and the level of general collateral-LIBOR spreads. To convert the asset swap to an inflation swap, the receiver of TIPS flows--the payer of LIBOR--needs to do another swap and pay fixed against receiving LIBOR. Since this swap probably would be executed as a spread in the LIBOR market, the trader would then have two swaps and an offsetting breakeven inflation position: long Treasuries, short TIPS against the swap position paying fixed and receiving TIPS flows.
This week's Learning Curve was written by Michael Ashton, inflation product manager at IXIS Capital Markets in New York.
