Business Briefing: How do you manage inflation uncertainty?
Published: Jun 2013
The Bank of England (BoE) has missed its 2% inflation target for the past 41 consecutive months. How will it manage the inflation environment going forward, and how should corporates analyse and quantify their explicit and implicit inflation risk?
Aled Patchett and Andrea Loddo of Lloyds Bank propose an approach that treasurers may adopt in order to determine their net inflation exposure and the most effective response in different inflation scenarios.
“Given the challenging economic environment in the UK, there is a level of uncertainty as to the inflationary pressure in the coming years,” notes Aled Patchett of Lloyds Bank’s Risk Management Solutions team. The Bank of England (BoE) has missed its 2% inflation target for 41 consecutive months, and instead its monetary policy is clearly allowing inflation to hover around 3%.
Elsewhere, as China puts restrictions on property investment in order to try to cap inflation, the Bank of Japan (BoJ) has been taking the view that inflation should rise in an attempt to stimulate the economy, and has set about doing this by printing more money. In such an uncertain environment, corporate treasurers should consider defining an appropriate strategy to reduce the impact on their business of uncertainty related to market movements and central banks actions.
The real debate around managing inflation risk starts with how a business quantifies its level of exposure, says Andrea Loddo of Lloyds Bank Financial Risk Advisory group. Some companies may argue that they do not have exposure to inflation; however a more thorough analysis may highlight that in fact inflation does indeed have an impact on financial performance.
A company may begin to determine its exposure to inflation through either a qualitative scorecard analysis or a quantitative analysis. In order to quantify the correlation between revenues and inflation, the latter may require some detailed modelling and historic revenue streams analysis. These revenue streams should be adjusted in order to strip out any change in revenues arising through, for example, M&A activity. However, if it is a well-established operation with predictable revenue streams, it will be relatively easy to establish the dependence of inflation to key performance indicators (KPIs).
Given the potential impact on KPIs, it is important that treasurers understand the precise nature of their exposure to inflation. Establishing whether companies are net receivers of inflation (with risk manifesting in prices, sales, contracts and subscriptions or property value for example) or net payers (eg labour costs, lease obligations, maintenance pensions or debt) is the first step that can help treasurers in quantifying the net exposure to inflation. After this exercise has been completed, the treasurers can decide if actions should be taken to mitigate the net inflation exposure; it may transpire that doing nothing is the optimal approach.
Chart 1: Quantifying your net exposure to inflation risk
If we look at the inflation market, inflation break-even rates are historically more volatile on short maturities. Chart 2 shows the historical distribution of inflation breakeven rates over the past nine years. Break-even rates beyond the 10-year maturity are relatively less volatile. The relative ‘stickiness’ of inflation on long tenors has probably been one of the motivations behind the “no action policy”, but Loddo warns against complacency.
Chart 2: Historical distribution of inflation breakeven rates (over nine years)
Understanding inflation risk
The impact of inflation on a business manifests itself in both cash flows and the balance sheet. For businesses with 100% nominal debt and revenues linked to inflation, a high inflationary environment is beneficial because their nominal debt is essentially eroded while their revenues rise. However, a low inflation scenario will be detrimental for this type of company.
Treasures should consider protecting the shareholders from significant moves in profitability driven by inflation. In a high inflationary environment, the ‘do nothing’ approach is perhaps an acceptable one. However, in a low inflation environment a business may find itself in a position where its debt is not eroding as quickly as anticipated and its revenues are stagnating, or even reducing. The impact of inflation is larger for companies with higher leverage, notes Loddo. It is then important to take into consideration the nature of the exposure to inflation. If, for example, costs rather than revenues exhibit inflation-linkage then under a high inflation environment the net profit would be eroded. This effect, however, would be naturally offset by nominal debt being eroded.
Few companies have assets and revenues that are 100% linked to inflation (such as the UK-regulated utility sector). Most commonly the asset valuation is simply the present value (PV) of the expected future cash flows. If cash flows are projected to increase in line with inflation (at least directionally), as inflation rises the PV of those cash flows increases, so the valuation of the assets increases and therefore the company could increase its debt capacity. Hence, it follows that if inflation falls the converse is true and the company may not be able to increase its debt capacity without increasing leverage. The leverage profile of a company may therefore be impacted by inflation and the magnitude of this impact is what we are trying to assess.
Accepting that inflation impacts a large number of companies, it is a little surprising that the number of entities hedging their inflation risk is in fact a relatively small subset of the market. UK utilities are one example: they have managed their inflation risk by either issuing inflation-linked bonds (such as National Grid and Anglian Water) or using inflation swaps to transform their nominal debt into inflation linked debt. Some others that have also adopted inflation solutions are transport infrastructure owners (such as BAA and Network Rail), major retail supermarkets, some telecom players and companies in the real-estate sector (rental streams tend to be long term and linked to inflation).
In this context, it is important to highlight that hedging per se is not always the optimal decision. A thorough analysis of the business may show the net inflation position, as there will likely be natural offsets which mitigate the overall exposure to inflation. It is important that the treasurer understands what tools they have available to them to mitigate the inflation exposure when necessary. With continued inflation uncertainty, now is a good time for treasurers to think about this topic, says Loddo.
Traditional inflation risk mitigants
A number of Lloyds’ clients have adopted a hedging strategy that utilises revenue inflation swaps. They remove uncertainty by swapping variable inflation-linked changes with known uplifts to the revenue stream. This enables clients to finance their business knowing exactly how much debt they can support over the period, and also gives the bank more certainty in terms of the company’s cash flow streams.
Traditionally revenue inflation swaps have been long dated, as the market is more liquid at longer tenors, and Loddo notes that the reduction of uncertainty around inflation in this way may help the company generate more accurate forecasts, leading to a more solid and predictable business plan.
Businesses with long-dated infrastructure-type assets, such as private finance initiatives (PFIs), adopt risk management strategies based on removing uncertainty from cash flows. As a result they will commonly enter into long dated swaps at the outset of the project to allow them to focus on managing the business and the elements that they can control. They are therefore hedged against future market movements from a cash flow perspective.
Case study
Mitigating inflation-linked risk
Although inflation can manifest itself in different aspects of the business, such as labour cost, revenues, asset values and maintenance, the factor that typically captures the attention of treasures is the linkage of inflation to revenue streams. In this particular case, possibly the most frequent solution is to reduce the exposure via income swaps.
As an alternative solution, a company can achieve the same risk mitigation effect by looking at a more holistic approach. This approach shows how inflation risk related to cash flows can be efficiently reduced by optimising the current debt mix via inflation linked debt. There are two ways of introducing inflation linked debt: either via issuing indexed linked debt or by swapping a portion of existing nominal debt to inflation via inflation swaps.
The case study is based on a company with £100m net debt and £40m EBITDA, which we assume to have a 20% linkage to inflation over the next three years. We also assume a cost of debt of three month GBP LIBOR + 200bps. We will quantify the cumulative cash flows (EBITDA – Interest Expense) over a three-year horizon under three different debt mix combinations: 100% Fixed, 100% Floating, and 90% Fixed 10% Inflation linked (IL). Additionally, we will evaluate the cumulative cash flows under three different scenarios: expected (as implied by current market forward rates); high rates-high inflation; and low rates-low inflation. The aim is to establish under which scenario one of the three debt mixes can have cost reduction benefits.
Charts 3 and 4 show the expected cumulative cash flows (Y axis) versus the cumulative cash flows under the high rate-high inflation scenario (X-axis, left chart), and low rate-low inflation scenario (X-axis, right chart). On an expected basis, the cumulative cash flow does not materially differ for the three debt mixes. This is because under the current market forward rates, the three debt combinations are, from a cost perspective, similar. However, on a stressed case basis, the three debt mixes exhibit different cost profiles.
Chart 3: Expected versus high inflation – high rates cumulative cash flows (over three years)
Under a high inflation-high rate scenario, the 100% Fixed is optimal. By adding IL debt (90% Fixed-10% IL) the increase in EBITDA is partially offset by higher interest expense on the IL debt.
Conversely, in a low inflation-low rate scenario, as expected, the opposite is true and the 100% Floating debt mix is now optimal. The 90% Fixed-10% IL debt mix outperforms the fixed debt mix. This is because the IL debt acts as natural hedge and offsets the decrease in EBITDA due to lower inflation.
Overall, the relative stable position of the grey dot compared to the alternative debt mixes under different market scenarios demonstrates how the inflation risk in EBITDA can be mitigated by adding a portion of IL debt.
Chart 4: Expected versus low inflation – low rates cumulative cash flows (over three years)
An alternative: inflation-linked debt and swaps
IL debt has traditionally been used by UK utilities, for example, to hedge their IL assets. Unlike nominal bonds, IL bond’s coupons and principals change with inflation.
However, this solution is not necessarily applicable only to utilities. Indeed, it is of no real benefit where a company has little or no exposure to inflation in its business, and it may even exhibit a higher risk profile due to the uncertainty of the final principal payment. But in a low inflation scenario, where there is direct or indirect exposure to inflation that is reflected in the company’s earnings, a portion of interest-linked debt can act as natural hedge, mitigating the overall exposure of the business to inflation. IL debt does not require more attention or scrutiny than other debt – it is just an alternative with a different risk profile and, depending on the business, it may or may not make sense.
Chart 5: Cumulative interest expense for fixed, floating and IL debt (over three years)
Companies that consider IL debt may also look at IL swaps as a solution to achieve a similar profile. In considering IL swaps, it is necessary to understand why a business would move from a cash flow hedging angle (specific to businesses which have clear exposure to inflation on a revenue line) to the more holistic balance sheet hedging approach required by IL debt.
Patchett suggests that the IL swap is attractive, from a cash flow perspective, as a hedge against direct or indirect exposure to inflation. In the short term it exhibits positive carry benefits compared to nominal debt (fixed or floating). This is because in the current environment real rates (which can be approximated by nominal rates minus inflation) are negative. As a result, interest expense associated to inflation would be negative in the short term. The caveat here is that at maturity, the company pays the inflation uplift on the initial notional; this explicit inflation linkage may prove too much of a risk for some corporates.
Conclusion
It is crucial here to restate the importance of considering a holistic approach which does not focus exclusively on revenues but includes IL costs as well, such as labour or maintenance. The real aim is not to hedge the largest and most explicit exposure in isolation, but to achieve the right strategic solution which will take into account the natural hedging characteristics associated to each exposure.
It is then important to establish how this approach fits in the overall strategic plan of the company. “The choice of instrument should have a clear motivation behind it,” advises Loddo. Ultimately, IL debt/swap may help companies to achieve a desired risk profile. While these solutions can be efficient from a risk management perspective, the accounting implications should also be understood.
Lloyds Bank
Andrea Loddo and Aled Patchett are experts on Risk Management Solutions for Lloyds’ corporate clients.
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