Merrill Lynch, Deutsche Bank and Lehman Brothers are structuring credit derivatives linked to European rates of inflation and predict this could become a major market this year. "Inflation is one of the key benchmarks for funds and insurance companies...The market is limitless," said Tony Main, v.p. in the global credit derivatives group at Merrill Lynch in London. Mike Tims, chief executive of medium-term note data provider mtn-i.com in London, said the increase in inflation products could be explained by inflation fears on the back of anticipated oil price spikes, coupled with bond investors looking for
a yield pickup.
Legislation pending in Italy that will require pension funds to provide investors returns at a minimum of 75% of the rate of inflation, will open the door for selling a mass of inflation-linked credit products to Italian managers. At the same time supply of inflation-linked bonds has rocketed. In the first six weeks of this year, there has been a total of EUR750 million (USD800.31 million) of euro-denominated inflation-linked issuance, compared with EUR1.5 billion for the whole of last year, according to mtn-i.com.
Merrill is structuring its first tranche of a CDO linked to inflation, according to Main. However, even plain vanilla inflation-linked credit derivatives can give investors a yield pickup. Structures linked to AA corporate names would give investors that have traditionally purchased inflation-linked cash government bonds a yield pickup in the region of 30 basis points and would offer corporate bond investors protection against inflation and a more modest yield pickup.
Rashid Zuberi, co-head of interest rate structuring at Deutsche Bank in London, said inflation linked credit products will be the biggest thing in the hybrid derivatives product market this year. Deutsche Bank began structuring these products last year, executing approximately five transactions intermittently, but has sold at least that many so far this year. Georges Assi, director in structured credit trading at Lehman in London, said he expects demand for complex inflation-linked credit notes to grow this year, adding that Lehman structured its first product last year. Colin Alexander, director in global credit trading at UBS Warburg in London, said the firm has looked at the possibility of doing more complex inflation-linked credit-linked notes and would have the capability if a client requested it, but has not executed any deals so far.
