Barclays, RBC offer contrasting CPI-linked notes with distinct fixed-rate periods, returns

By Emma Trincal

New York, Jan. 19 - Several Consumer Price Index-linked notes hit the market or will be priced this month as issuers respond to investors' demand for an inflation hedge.

Barclays Bank plc priced $5.5 million of floating-rate notes due Jan. 27, 2017 linked to changes in the CPI, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will accrue at 5% for the first year. After that, interest will be 1.5 times the change in the CPI, subject to a cap of 8% and a floor of 0%. Interest is payable monthly.

Separately, Royal Bank of Canada plans to price fixed to floating inflation-linked notes due Jan. 28, 2020 tied to the Consumer Price Index, according to a 424B2 filing.

The notes will pay a fixed coupon of 3% for the first five years. Thereafter, the coupon will be equal to the year-over-year change in the CPI plus a spread of 100 basis points, with a floor of 0%. Interest is payable monthly.

The payout at maturity for both notes will be par.

In fashion

"We haven't done any inflation-linked notes recently, but I sense a renewed interest," said Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management in Atlanta. "It's probably due to the fact that people are more aware of the tremendous U.S. budget deficit and the potential inflation kicking in down the road."

For some, inflation fears are a lesser worry than a double-dip recession or long-lasting deflation, sources said, pointing to gold trading down or sideways since early December as an indicator than expectations of higher prices have been reduced. Even for investors who believe that the U.S. recovery is underway, inflation is often not seen as an immediate risk.

Last week, data from the Department of Labor eased inflation concerns when it showed the CPI rising only 0.1% in December, less than forecast, following a 0.4% gain in November. Overall, the CPI rose 2.7% in 2009.

Tony Romero, co-founder and managing partner at Suncoast Capital Group, a Miami-based deposit brokerage firm, said, "CPI is very difficult to predict a month in advance, let alone seven or 10 years from now. Buying those notes is a little bit like going to Las Vegas. If you think rates are going to go up, then you believe CPI will rise too."

Leverage versus sum

Comparing the floating payouts of both deals - on the one hand, RBC delivers uncapped returns linked to the CPI plus 1%, and on the other hand, the Barclays product offers a 1.5 times participation rate but is limited by an 8% cap - Romero said, "Barclays is better just looking at all assumptions, assuming a CPI at 3%, 4% or 5%. For instance with 4%, RBC gives you 5%, Barclays, 6%. In most assumptions, the second one gives you a higher result. I would choose the Barclays for the potentially higher return."

Cap is fine

Looking at the 8% cap associated with the Barclays note, Romero added, "It's fine. I have no problem with that. It gives you a lot of room for error. You would have to have a CPI of about 5.35% to hit the cap and still, you would be better than the other product. It's only if CPI hits 7% that you would be better off with the RBC deal. Since I don't see that happening, I prefer the Barclays."

If the CPI hit 7%, the RBC notes would deliver after the fifth year an 8% return while investors in the Barclays product would see their payout capped to 8% instead of receiving the 10.5% that would result from the leverage.

"I find it hard to believe that CPI could hit 7%. It's possible, but it's unlikely," said Romero. "However, seven years is a long time. A lot of different scenario could happen in seven or 10 years, including another terrorist attack, which is why I find it unrealistic to make those long-term inflation bets."

During the floating period, the RBC notes provide a better return than the Barclays product assuming that the CPI is less than 2%. If the CPI is higher than 2%, the 1.5 times leverage provided by Barclays gives investors a superior result than the inflation index plus 100 bps.

Beware lock-ups

Gabriel Burstein, global head of fund research at Lipper Inc., a unit of Thomson, said that his choice depends mostly on the length of time during which investors would be locked in with a fixed interest rate.

"With the first one [the RBC product], your return is capped to 3% for five years, while you're only locked in for one year with the second deal, and at a higher rate of 5%. The RBC deal is not connected to inflation at all. We already are at 3%. It gives you zero participation to the coming inflation and for as long as five years. That's a problem because the next five years are going to be crucial years of inflation. You don't want to be stuck with a 3% annual return during that time." Burstein said.

"On the other hand, the other deal gives you a very good participation in the higher inflation trend; it kicks in just after the first year, so I think it offers a much better hedge against inflation."

Burstein said that the negative aspect of the 8% cap imposed by the Barclays structure is non-existent if inflation remains below the 5.35% threshold. "The 8% cap in my view is not an issue here because I don't think U.S. inflation will get to 5.35%. I think the days of inflation below 2% are over, but I don't anticipate more than 5.35%," Burstein said.

Hyperinflation scenario

However, Burstein added, if the hyperinflation scenario was to unfold, investors then would be "better off" with the RBC deal, as it has no cap.

In conclusion, Burstein said that both investments could find their place in a portfolio since it is a challenge to make accurate predictions on the future level of inflation as well as its exact timing.

"Maybe an investor could combine those two notes in a diversified portfolio," suggested Burstein. "The Barclays product would give him a short-term immediate hedge against inflation as it kicks in immediately after the first year. And the RBC notes after five years would offer more value if double-digit inflation was to become reality. But I would start with the first one in order to stay hedged against raising prices for the first three to five years."

Barclays Capital Inc. is the agent for the Barclays notes, which priced on Thursday and will settle on Jan. 27.

RBC Capital Markets Corp. is the underwriter for the other notes, which are expected to price in January and settle on Jan. 28.

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