LDI Monthly Wrap. Monthly market update. What you need to know. Market Conditions as at COB 30 November Key Events and Data.

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1 DECEMBER 2015 LGIM LDI FUNDS LDI Monthly Wrap. Monthly market update What you need to know Robert Pace Senior Product Specialist Anne-Marie Cunnold Senior Product Specialist After last month s action in gilt z-spreads there was more of the same in November with the key 30 year gilt z-spread metric hitting 60bps before ending the month at less extreme levels albeit elevated compared to recent history. Demand for ultra long yields remained strong as reflected in the downward movements in 50 year yields (both gilts and swaps) compared to shorter maturity rates. The DMO was under pressure to provide supply in this area for January to March 2016 which, post month end admittedly, we now know has been granted with greater emphasis on ultra long conventional gilts compared to normal Central banks remained a hot topic of discussion with high anticipation for what the ECB would do (now known to be not very much) and the US come December. This can be seen in the credit default spreads with European spreads narrowing whilst US spreads widened. The UK remains next year s news in terms of any interest rate rises from the Bank of England The 2046 syndication is included in the table below by virtue of being planned for the second half of November or early December. All the metrics indicated strong demand for the last major opportunity for hedging in 2015 and indeed the DMO will actually be auctioning the bond again come January which is a surprise and suggests that banks are short the bond Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 30 November 2015 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.71% 2.53% 2.40% Gilt Real Yields -0.86% -0.77% -0.91% Gilt Breakeven Inflation 2.57% 3.31% 3.31% ZC Swap Rates 1.87% 2.03% 1.87% RPI Swaps 3.10% 3.43% 3.42% Gilt Z-Spreads (vs. 6mL) Linker Z-Spreads (vs. 6mL) IOTA (Relative z-spread) Equities, Volatility & Credit Current Monthly Change FTSE 100 6,356-5 S&P 500 2, y30y Swaption Vol 37.1% +0.6% FTSE 100 Implied Vol 19.7% +0.4% CDS - 10y itraxx (bps) CDS - 10y CDX (bps) m LIBOR (bps) Key Events and Data Region Period Actual Consensus Prior Comments US non-farm payrolls US Oct 271, , ,000 US GDP UK Q % 0.5% 0.5% UK Base rate decision UK Nov 0.5% 0.5% 0.5% UK CPI UK Oct -0.1% -0.1% -0.1% Annual inflation UK RPI UK Oct 0.7% 0.9% 0.8% Annual inflation UK unemployment UK 3m to Sep 5.3% 5.4% 5.4% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 1 Dec 2015 Syndication 0 1/8% Index-linked Treasury Gilt % NA 18 Nov 2015 Auction 2% Treasury Gilt % Nov 2015 Auction 4¼% Treasury Gilt % Nov 2015 Auction 0 1/8% Index-linked Treasury Gilt % 1.79

2 DECEMBER 2015 LGIM LDI FUNDS 2 Market Data Interest rates in the credit default spreads with European spreads narrowing whilst US s England The 2046 syndication is included in the table above by virtue of being pla last major opportunity for hedging in 2015 and indeed the DMO will actuall bond Rate (%) Y ZC IRS 30Y ZC IRS Inflation remains next year's news in terms of any interest rate rises from the Bank 4.0 of November or early December. All the metrics indicated strong demand again 3.8come January which is a surprise and suggests that banks are 'sho 3.6 Rate (%) Y Inflation Swap 30Y Inflation Swap Interest rate curve v Feb-15 May-15 Aug-15 Nov-15 10Y ZC IRS 30Y ZC IRS 0.5 Inflation curve Rate (%) 0.4 Rate (%) Y - 10Y Zero Coupon Interest Rate Swap 30Y - 10Y Inflation Swap Z-spreads Relative Z-spreads (IOTA) Z-Spread (bps) (10) (20) (30) Gilt 2025 Gilt 2044 ILG 2024 ILG 2044 IOTA (bps) (5) IOTA 2024 IOTA 2044

3 DECEMBER 2015 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding November 2014 October 2015 November 2015 SONIA 0.42% 0.45% 0.45% 3-Month LIBOR 0.55% 0.58% 0.57% 6-Month LIBOR 0.68% 0.73% 0.73% UK Gilt Total Return Swap: 6 Months 0.66% 0.86% 0.87% UK Gilt Total Return Swap: 1 Year 0.80% 0.94% 1.00% 6-Month Gilt Repo 0.68% 0.82% 0.81% 1-Year Gilt Repo 0.78% 0.88% 0.93% Note: TRS and repo pricing is transaction-based where possible, and can vary materially by counterparty, Bloomberg L.P. Swaptions market Interest rate swaption markets November 2014 October 2015 November Y/20Y ATMF+1%: Premium 2.21% 2.88% 2.70% 3y/20y zero-cost collar +1%/ Y 1.01% 1.12% 1.12% ATMF (implied 20Y rate in 3Yrs) 2.63% 2.35% 2.21%, Bloomberg L.P. HeatMap: zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.84% 1.05% 1.12% 1.15% 1.21% 2y 0.91% 1.10% 1.15% 1.17% 1.22% 3y 0.93% 1.05% 1.10% 1.12% 1.17% 4y 0.96% 1.09% 1.12% 1.13% 1.16% 5y 0.97% 1.10% 1.13% 1.13% 1.12%, Bloomberg L.P.

4 DECEMBER 2015 LGIM LDI FUNDS 4 Market Data UK (FTSE 100) November 2014 October 2015 November Y 90% Put: cost 3.32% 4.18% 4.27% 1Y 90/70 put spread: cost 2.59% 3.13% 3.17% 1Y zero cost 90/70 Put Spread Collar: "X" % % % FTSE 100 Implied Volatility FTSE 100 Forward/Spot US (S&P 500) November 2014 October 2015 November Y 90% Put: cost 3.64% 4.09% 4.26% 1Y 90/70 put spread: cost 2.70% 2.93% 3.00% 1Y zero cost 90/70 Put Spread Collar: "X" % % % S&P 500 Implied Volatility S&P 500 Forward / Spot Europe (Euro Stoxx 50) November 2014 October 2015 November Y 90% Put: cost 4.36% 5.28% 5.48% 1Y 90/70 put spread: cost 3.48% 3.92% 3.96% 1Y zero cost 90/70 Put Spread Collar: "X" % % % Euro Stoxx 50 Implied Volatility Euro Stoxx 50 Forward / Spot Equity Replacement Strategies Equity Replacement Strategies November 2014 October 2015 November 2015 UK 1Y 100% Call 4.29% 5.09% 5.31% 1Y 105% Call 2.24% 2.93% 3.11% US 1Y 100% Call 5.60% 5.90% 6.28% 1Y 105% Call 3.19% 3.39% 3.73% EUR 1Y 100% Call 5.66% 6.57% 6.72% 1Y 105% Call 3.66% 4.47% 4.58%, Bloomberg L.P. Note: all strikes quoted as a percentage of spot for transparency. for informational purposes we also show the ratio of the forward/spot index level in the table because the forward index level drives the option price. Therefore, this enables better like for like comparisons across different countries. For example, a 100% strike in the UK (as a percentage of spot) will be different to a 100% strike in the US when related to the strike as a percentage of forward.

5 DECEMBER 2015 LGIM LDI FUNDS 5 In Focus What would it take for a 2075 index-linked gilt? The Pension Fund, the DMO and the GEMMs In 2005 the Debt Management Office (DMO) issued the 2055 index-linked gilt, which was the first inflation-linked 50 year bond. Since then the maturity of the UK government bond market was extended beyond 50 years when the 2068 conventional and index-linked gilts were issued following a DMO-led consultation in After thorough consideration, taking into account the feedback received in response to the DMO s consultation, the Government has taken the following decisions: to remove the current maturity cap on gilt issuance set at around 50 years; in to look to launch new issuance in the year area, subject to demand and market conditions; and not to introduce new perpetual gilts at the current time Source: Super-long and perpetual gilts, Response to consultation, DMO, 5 December 2012 Pension funds clearly have liability cashflows which extend beyond 50 years and beyond So, what would it take for longer maturity government bonds to fill that void? This edition of In Focus addresses some of the key discussion points from the perspective of three key stakeholders; pension funds, the DMO and the Gilt-edged Market Makers (GEMMs). Whilst some of these issues were raised in 2012 we think that three years on there is merit in revisiting this area, given its topical nature. The final syndication of the fiscal year is expected to take place in February 2016 and there is certainly a strong possibility of the real yield curve being extended with 2075 at the upper maturity range: Syndication: Investor attendees who expressed a view unanimously recommended holding the index-linked transaction in February. There was a strong preference for ultra-long supply, with those who preferred there to be a conventional gilt of equivalent maturity alongside recommending the launch of a new index-linked gilt maturity in 2065 or the re-opening of IL Other attendees, however, recommended a new longer gilt to reflect the strength of demand for duration; 2070, 2072, 2073 and 2075 maturities were all mentioned. Overall, we believe that a 2075 index-linked gilt would be a useful part of the hedging toolkit and probably preferable to a shorter extension versus the existing 2068s. Pension fund perspective Risk: Pension fund liabilities stretch out beyond 50 years (and beyond the current longest dated gilt which matures in 2068). Our approximate calculations indicate that 2% to 3% of liability valuations (on average) could relate to cashflows beyond 50 years. Given 2 trillion of pension fund liabilities then that translates to around 50 billion. Figure 1. Average scheme cashflows C.20y duration 60% Non Pensioners 40% Pensioners Source: DMO minutes 30 November

6 DECEMBER 2015 LGIM LDI FUNDS 6 As a neutral position is often viewed as a pro rata hedge across the curve this implies that there would be merit in considering hedging these longer maturities. It would also avoid the existing issue whereby the asset sensitivity at the 50 year tenor point gradually rolls off whilst the liability sensitivity stays relatively constant (because of the 60 and 70 year cashflows). In fact pension funds are often keen to use very long duration bonds as an alternative to combining shorter maturity bonds with leverage, meaning that 2075 is likely to be a popular addition. Return: The downward sloping yield curve and historically low forward rates may mean that some schemes are happy to stay in the 2068s instead. That said, bringing a 2075 bond to market via syndication is likely to result in a concession and more attractive valuations. As we have remarked before, syndications often prove attractive entry points for government bond purchases. Figure 2. 0 Gilt Yield Curves 3 Real yield (%) ZC real yield curve (gilts) ZC gilt curve analytics Nominal yield (%) Other considerations: Those schemes using gilt and index-linked collateral would need to confirm that over 50 year bonds are eligible (although we note that much of this was picked up with the first issuance beyond 50 years). Swaps are currently only centrally cleared out to 50 years so any asset swaps would definitely have to use uncleared swaps. At the same time if a liquid 60 year swap market did develop then it would seem a natural candidate for optional clearing. DMO perspective The objective of the DMO is shown below: Debt Management objective 2.3 The debt management objective, established in 1995 following the Debt Management Review, is: to minimise, over the long term, the costs of meeting the government s financing needs, taking into account risk, while ensuring that debt management policy is consistent with the aims of monetary policy. Consequently, any return concerns that pension funds might have around the shape of the yield curve is almost a positive for the DMO given its mandate. Of course this is not the only consideration for the DMO and the following are some of the risks it highlights: 2.6 A number of risks are taken into account when selecting possible debt management strategies. Five particularly important risks are: interest rate risk interest rate exposure arising when new debt is issued refinancing risk interest rate exposure arising when debt is rolled over, with an increase in refinancing risk if redemptions are concentrated in particular years inflation risk exposure to inflation for the indexation of coupons and principal of index-linked gilts liquidity risk the risk of insufficient liquidity for the government to borrow from a particular part of the market in the required size at a particular time execution risk the risk the government is not able to sell the offered amount of debt at a particular time, or must sell it at a large discount to the market price Of note, liquidity is likely to be a concern, both now and in the future. Inflation risk may also be an issue given the long timeframes involved and the potential for high inflation and a higher subsequent cost of debt. There was also a very robust statement around the pitfalls of RPI in the Johnson review albeit this was rebuffed by the DMO. Hence any RPI issuance which extends the maturity of the current bonds may need careful consideration.

7 DECEMBER 2015 LGIM LDI FUNDS 7 The issuance of index-linked gilts is more complex, but the government should move away from selling gilts linked to the RPI, subject to consultation and assurance about the demand for CPI or CPIH linked gilts. Source: UK Consumer Price Statistics: A Review Paul Jonnson, January 2015 GEMM (Gilt-edged Market Maker) perspective Investment Banks are there to make markets. The following is an extract from the GEMM guidebook by the DMO: GEMMs are committed to make, on demand and in all conditions, continuous and effective two-way prices to their customers in all gilts in which they are recognised as a market maker. Consequently appetite for longer bonds is likely to be influenced by the targets the DMO sets and whether there are any adverse consequences from extending the market. For example, the 2012 consultation specifically commented on balance sheet concerns associated with very long duration bonds and we know these issues have probably become more pronounced rather than less. Ultimately if there is sufficient client demand and liquidity then we would not expect the GEMMs to have any major concerns. The question marks therefore relate to the fact that over 50 year bonds are not cleared and that no liquid 60 year market exists at present. There would have to be an expectation that these hurdles could be overcome as a 2075 bond came to market. Indeed, based off the 30 November DMO minutes, it seems that the GEMMs are comfortable with this possibility and would not necessarily require a 2075 conventional gilt first: In terms of maturity, views were broadly split between the launch of a new index-linked gilt maturing in 2065 or a new gilt that would extend the real yield curve, with 2070, 2072 and 2075 all suggested as possible redemption years. There was an isolated call for a new gilt in the 20 to 30-year maturity area and a few other calls for a re-opening of an existing index-linked gilt. Conclusions Pension funds (and insurers) are an important part of the DMO client base (around 30% as shown in the chart below). The 2068 gilts and index-linked gilts have clearly been very successful bonds to date so the concept of extending the yield curve seems natural. 100 year bonds may make headlines but were 60-year index-linked gilts (and potentially 70-year down the line) to be issued, this would probably be sufficient to match the great majority of pension fund liabilities. Figure 3. Gilt holdings by sector ( billion, market value) Q3 0% -2% 3% Banks and building societies UK households 25% 2014 Q3 9% 1% 32% Insurance companies and pension funds Local authorities and public corporations 29% 17% 0% 50% Non-financial private corporations and other financial institutions Overseas Bank of England Asset Purchase Facility Fund Ltd 2 28% 0% 7% 1 Figures may not sum due to rounding 2 The Bank of England s holdings of gilts not related to the Asset Purchase Facility are included in the Banks and building societies category. Source: ONS and Bank of England

8 DECEMBER 2015 LGIM LDI FUNDS 8 Swaptions educational refresher The collar heatmap on page 3 shows the distance from the ATMF at which the receiver swaption would have to be bought in order to create a zero cost collar where the sold payer swaption is fixed at the ATMF+1%. This is shown across a range of option maturities (1-5 years) and underlying swap tenors (5-30 years). The colours of the heatmap are explained on page 8. Swaptions educational refresher ATMF stands for at-the-money forward and is the level at which the markets imply 20-year swap rates will be in 3 years time. This is different from today s 20-year swap rate. 3y20y ATMF+1% premium: This is the premium that a scheme receives, up-front, if it sells a 3y20y payer swaption to a bank with a strike of ATMF+1%. As an example, if the 3-year ATMF is 1.5%, this means that a scheme could sell a 3y20y payer swaption with a strike of 2.5%, for which it would receive the premium shown in the table. Then, at the end of the 3-year period: If 20-year swap rates are higher than 2.5%, then the scheme would either enter into a 20-year interest swap, where the bank pays it a fixed rate of 2.5%, or cash settle the contract. Effectively, the scheme will have hedged the interest rate exposure at a rate of 2.5%, rather than the higher rate then being offered in the markets. If 20-year swap rates are lower than 2.5% at the end of the 3-year period, then nothing happens the swaption expires unexercised. Whatever happens to swap markets, the scheme keeps the premium on top of the result shown above. 3y20y zero-cost collar +1%/ Y: If the scheme sells a payer swaption, one possible use of the premium received is to buy protection against falls in future swap rates, since liability values typically increase when swap rates fall. Y is the level below which the scheme would be able to receive protection if it bought a 3y20y receiver swaption using all of the premium received from selling the 3y20y payer swaption. This leads to a zero-cost swaption collar. The end result with such a collar is that the scheme pays no premium up-front: The scheme is protected against falls greater than Y in 20-year swap rates, relative to the current implied swap rate in 3 years time. Hence the smaller the value of Y, the more protection there is. The scheme effectively hedges the interest rate exposure at ATMF+1% (i.e. it loses any gains from increases in 20-year swap rates of more than 1%, relative to the expected swap rate in 3 years time). Key risks The use of derivatives may expose schemes to additional risks. Please see the Key Risks information on page 8. Swaption: impact (for illustrative purposes only) Swaption collar: impact (for illustrative purposes only) Nominal liability value Unhedged exposure to rates 0% 1% 2% 3% 4% Unhedged Position ATMF 20-year swap rate in 3 years Hedge provided if rate goes above ATMF+1% Position with Sold Swaption Nominal liability value Y Protection against fall in rates to below ATMF - Y ATMF Hedge provided if rate goes above ATMF+1% 0% 1% 2% 3% 4% 20-year swap rate in 3 years Unhedged Position Position with Zero-Cost Collar

9 DECEMBER 2015 LGIM LDI FUNDS 9 Equity options educational refresher Equity options educational refresher Implied volatility: FTSE 100 Volatility Index, an index of the short-term volatility in the FTSE 100 (over the next 30 days) as implied by the pricing of FTSE 100 options. 1Y 90% put cost: This is the up-front premium that a scheme has to pay to receive protection against falls of more than 10% in the FTSE 100 Price Index over the next one-year period (i.e. physical equities are held and a 90% put option is purchased). If the market goes up, full exposure is maintained to increases in the index. Dividends are received from the physical equities. So, for example, if dividends are 3% then the maximum loss in total return terms would be 7%. Whatever the end level of the index, the premium is lost since it is paid up-front. 90% put payoff (ignoring premium) (for illustrative purposes only) 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 60% 80% 100% 120% 140% Price Index 90% Floor 1Y 90/70 put spread: This type of put spread has the payoff profile shown, at the 1-year option expiry when combined with a current FTSE 100 equity holding. This structure ensures that the scheme won t lose more than 10% unless the index drops by more than 30% at expiry of the options. This protection is achieved using a put bought with a strike at 90% of the current index level and a put that is sold 30% below the current index level (70%). The premium of the 90% strike put will be larger than the premium of the 70% put, so there is an upfront premium to be paid in this strategy that is the cost of the 90% put minus the premium gained selling the 70% put. If the market goes up, full exposure is maintained to increases in the index (minus the upfront premium cost). Dividends are received from the physical equities. So, for example, if dividends are 3% then the maximum loss in total return terms would be 7% if the index falls by less than 30%. Whatever the end level of the index, the premium is lost since it is paid up-front. 90/70 put spread payoff (ignoring premium - for illustrative purposes only) 140% 130% 120% 110% 100% 90% 80% 70% 60% Zero-cost 90/70 put spread collar payoff (for illustrative purposes only) 140% 130% 120% 110% 100% 90% 80% 70% 60% 50% 70% 90% 110% 130% Price Index Protection against market falls of between 10% and 30% Protection against market falls of between 10% and 30% 50% 70% 90% 110% 130% Price Index Zero-Cost Put Spread Collar 1Y zero-cost 90/70 put spread collar: X: This type of put spread collar has the payoff profile shown below, at the 1-year option expiry when combined with a current FTSE 100 equity holding. This structure ensures that the scheme won t lose more than 10% unless the index drops by more than 30% at expiry of the options. This protection is achieved using a put bought with a strike at 90% of the current index level and a put that is sold 30% below the current index level (70%). A scheme participates in index rises, but only up to the level (X) shown. The 90/70 downside protection is paid for by selling the upside potential in price returns at X and receiving a premium in return. Hence a scheme would theoretically pay no premium up-front for this structure (excludes dealing charges) (i.e. X is set so that it covers the necessary upfront premium for the 90/70 downside protection). The equity option structure is based on returns on price indices, whereas investing in a physical equity will generate returns over and above this to reflect dividends received Upside participation up to level of X 100 X Zero-Cost Put Spread Collar Key risks The use of derivatives may expose schemes to additional risks. Please see the Key Risks information on page 8.

10 DECEMBER 2015 LGIM LDI FUNDS 10 Supporting material Explanation of swaptions indicators In our swaption collar heatmap table we show how the most recent value compares to the last 12 months worth of weekly data. We mark an indicator in dark green or red if the value of the indicator is in the top or bottom 10%. Light green or red is used for the top or bottom 20% whilst blue is for no significant change. Gilt Total Return Swaps (TRS) In our short-term interest rates and funding table on page 4, we refer to UK Gilt Total Return Swaps (TRS). Prices are quoted in basis points (1 basis point = 0.01%). For example, 0.55% for UK Gilt Total Return Swap: 1 Year means that a scheme can receive the total return (including coupons) on a liquid conventional gilt over a 1-year period, in return for paying 0.55% pa. Repos Repos are also referred to in our short-term interest rates and funding table on page 3. A repo is an agreement to sell and repurchase securities at an agreed future date, at a specified price. They are most liquid at shorter maturities, typically up to 6 months, but can trade as long as 12 months. Repo pricing is shown as an annualised fixed funding cost for 6-month and 1-year contracts. Interest rate and inflation markets Graphs for UK interest rate and inflation market data are shown on page 2. We show standard zero coupon swaps: interest rate swaps where the stream of fixed-rate payments is made as one lump-sum payment when the swap reaches maturity, and standard zero-coupon: inflation swaps where the swap receipts reflect the UK Retail Prices Index. The numbers in the bottom tables show the yield available from gilts, relative to the yield available from swaps (sometimes known as the z-spread). In addition, we show IOTA, which is the relative value between gilt breakeven and swap inflation. The definition used in this document is Index Linked Gilt Z-Spread minus Nominal Gilt Z-Spread. Data key Positive for underfunded/ underhedged scheme - Yield increase by 15+bps, inflation decrease by 15+bps No major move (all within +/- 15bps) Negative for underfunded/ underhedged scheme - Yield decrease by more than 15+bps, inflation increase by 15+bps Moves in swap spreads have different implications for different pensions schemes (so not colour coded) KEY RISKS Derivatives may have greater volatility than the securities or markets they relate to. A change in value of a derivative may not correlate to a change in value of the underlying instruments. This may result in losses greater than the direct investment in those securities or markets. OTC derivatives contracts held (directly or indirectly) are valued using vendor supplied, model based and/or counterparty based data. OTC derivatives are contracts with companies such as banks or other financial institutions. If these companies experience financial difficulty, they may be unable to pay back the sums that they owe under the OTC derivative contracts. CONTACT US For more information please contact: Robert Pace Anne-Marie Cunnold Femi Bart-Williams Senior Product Specialist Senior Product Specialist Senior Product Specialist robert.pace@lgim.com anne-marie.cunnold@lgim.com femi.bart-williams@lgim.com +44 (0) (0) (0) IMPORTANT NOTICE The information is produced by the LDI Funds Team at Legal & General Investment Management. Opinions expressed in this material may differ from those of other areas within Legal & General Investment Management. The instruments used have a range of different risk profiles and these should be understood by pension schemes before making any investments. Pension schemes should ensure they obtain suitable professional advice. The information contained in this document is not intended to be, nor should be, construed as investment advice nor deemed to be suitable to meet the needs of pension schemes Legal & General Investment Management Limited. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers. Legal & General Investment Management Ltd, One Coleman Street London, EC2R 5AA Authorised and regulated by the Financial Conduct Authority. M0657