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

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1 NOVEMBER 15 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 A bounce back for risk assets after the disappointment of Q3 15. As the data tables show, equities were up, credit spreads were narrower and yields were higher. For nominal yields the highlight of the month was the 65 conventional gilt syndication with a record order book in excess of bn. In advance of the syndication we saw 50-year yields increasing relative to 30-year yields before the trend reversed post syndication. The other highlight in markets was the continued increase in swap spreads with 30- year spreads reaching 50bps (depending on your exact choice of metric). We pick this up in detail later on within the In Focus section. Inflation rates moved higher in line with the nominal yield moves although shorter maturities looked more unloved. In the US, the unemployment data came in well below consensus. However, this is a volatile series and there is still time for the Fed to justify a December rise in interest rates. Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 30 October 15 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.79% 2.62% 2.51% Gilt Real Yields -0.74% -0.73% -0.85% Gilt Breakeven Inflation 2.53% 3.35% 3.36% ZC Swap Rates 1.96% 2.17% 2.03% RPI Swaps 2.98% 3.47% 3.46% Gilt Z-Spreads (vs. 6mL) Linker Z-Spreads (vs. 6mL) IOTA (Relative z-spread) Equities, Volatility & Credit Current Monthly Change FTSE 6, S&P 500 2, y30y Swaption Vol 36.5% -0.6% FTSE Implied Vol 19.3% -2.0% 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 Sep 142,000 2, ,000 Notably volatile series (October results were better for Fed) US GDP UK Q % 0.6% 0.7% UK Base rate decision UK Oct 0.5% 0.5% 0.5% UK CPI UK Sep -0.1% 0.0% 0.0% Year on year prices index UK RPI UK Sep 0.8% 1.0% 1.1% Year on year prices index UK unemployment UK 3m to Aug 5.4% 5.5% 5.5% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 22 Oct 15 Syndication 2½% Treasury Gilt % NA 27 Oct 15 Auction 2% Treasury Gilt % Oct 15 Auction 0 1/8% Index-linked Treasury Gilt % Oct 15 Auction 4½% Treasury Gilt % Oct 15 Auction 1½% Treasury Gilt % 1.49

2 NOVEMBER 15 LGIM LDI FUNDS 2 Market Data Interest rates Inflation pick this up in detail In Focus later on in this piece. oked more lation rates moved higher in line with the nominal yield moves although shorter maturitie 4.0 unloved. 3.0 and there is still time for the Fed to justify a December rise in interest rates. the US the unemployment data came in well below consensus although it is a volatile se Rate (%) Rate (%) Y ZC IRS 30Y ZC IRS 10Y Inflation Swap 30Y Inflation Swap Interest rate curve Inflation curve Rate (%) Y ZC IRS 30Y ZC IRS Y - 10Y Zero Coupon Interest Rate Swap Oct Jan-15 Apr-15 Jul-15 Oct-15 Rate (%) 10Y Inflation Swap 30Y Inflation Swap Y - 10Y Inflation Swap Z-spreads Y - 10Y Zero Coupon Interest Rate Swap Z-Spread (bps) 10 - (10) () (30) Gilt 25 Gilt 44 ILG 24 ILG 44 Relative Z-spreads (IOTA) Y - 10Y Inflation Swap 30 IOTA (bps) (5) IOTA 24 IOTA 44

3 NOVEMBER 15 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding October 14 September 15 October 15 SONIA 0.42% 0.35% 0.45% 3-Month LIBOR 0.55% 0.58% 0.58% 6-Month LIBOR 0.69% 0.75% 0.73% UK Gilt Total Return Swap: 6 Months 0.64% 0.82% 0.86% UK Gilt Total Return Swap: 1 Year 0.81% 0.93% 0.94% 6-Month Gilt Repo 0.63% 0.84% 0.82% 1-Year Gilt Repo 0.77% 0.93% 0.88% 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 October 14 September 15 October 15 3Y/Y ATMF+1%: Premium 1.99% 2.85% 2.88% 3y/y zero-cost collar +1%/ Y 1.04% 1.07% 1.12% ATMF (implied Y rate in 3Yrs) 2.99% 2.25% 2.35%, Bloomberg L.P. HeatMap: zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y y 30y 1y 0.92% 1.12% 1.15% 1.17% 1.21% 2y 1.02% 1.19% 1.19% 1.21% 1.23% 3y 1.00% 1.08% 1.10% 1.12% 1.17% 4y 1.03% 1.14% 1.14% 1.15% 1.16% 5y 1.00% 1.12% 1.13% 1.13% 1.12%, Bloomberg L.P. Equity options Equity market - FTSE October 14 September 15 October 15 1Y 90% put: cost 3.29% 4.91% 4.18% 1Y 90/70 put spread: cost 2.59% 3.53% 3.13% 1Y zero cost 90/70 put spread collar: "X" % % % FTSE Implied volatility , Bloomberg L.P.

4 NOVEMBER 15 LGIM LDI FUNDS 4 In Focus -1% is just a number. So is 50bps 15 has seen a few technical levels breached. Earlier in the year, we saw long-dated real yields slip below -1% for the first time whilst the latest development is in swap spreads (the difference between gilt yields and swap rates, also referred to as z-spreads). These have been creeping steadily higher and recently broke through 50bps for 30 year gilts, a level last seen in 09. In fact over the month of October we ve almost seen a 10bps move which is large in the context of historic changes (as the chart shows this is one of the biggest monthly moves in the last two years). Figure gilt z-spread 50 Spread (bps) /11/13 04/02/14 04/05/14 04/08/14 04/11/14 04/02/15 04/05/15 04/08/15 04/11/15 Levels are there to be broken and that is what has happened. In Focus this month therefore are swap spreads and in particular, how did we get here and where do we go from here? How did we get here? Hindsight is a wonderful thing and we need to be careful about fitting a story to what has happened. However, the key themes of 15 and plausible drivers for swap spreads to date are: Bank balance sheet contraction and the subsequent impact on repo Solvency II flows Execution of swaps UKT 3.25% 22-Jan-44 ; Bloomberg L.P. Repo The bank balance sheet story has been raised before and isn t new. That said it certainly seems to be the case that Basel III regulation is beginning to feed into bank behaviour more than it has done historically. Repo funding is more expensive than it used to be as Figure 2 demonstrates. Coming into year end there is a double hit as banks are always concerned about year end balance sheets. Figure 2. 3m Repo rate versus 3m LIBOR, Open Repo rate v SONIA (actual trades) History - Repo Rate Spread Over LIBOR Swap Rate 0.% 0.15% 0.10% 0.05% 0.00% 06/14 08/14 10/14 11/14 01/15 03/15 04/15 06/15 08/15 09/15 Repo 3M Repo OPEN

5 NOVEMBER 15 LGIM LDI FUNDS 5 A theoretical argument can be made that swap spreads should reflect future repo rates plus a premium for a credit risk around the bond. If we look at 10-year UK CDS then we see little change of late (unfortunately 30-year CDS are not a quoted instrument) but certainly this suggests that the recent changes in swap spread are more attributable to factors such as repo other than credit quality. Intuitively, it also makes sense that the marginal buyer of swap spreads would need a greater premium if they felt that it would be more expensive to fund that position in the longer term. Figure 3. UK 10-year CDS Spread (bps) /11/10 08/06/11 08/01/12 08/08/12 08/03/13 08/10/13 08/05/14 08/12/14 08/07/15 UK 10-year CDS spread Source: Bloomberg L.P. Other anecdotal evidence for funding playing a part in spreads rising is the relative difference between gilt swap spreads and index-linked swap spreads. At present both are very similar (normally one expects index-linked swap spreads to trade at a premium given their lower liquidity). One explanation for this is that index-linked gilts offer greater leverage without leverage. As their duration is much greater than the equivalent conventional gilt the marginal buyer of swap spreads may choose to use index-linked gilts because of the greater overall potential capital pick up. Figure 4. IOTA or relative z-spread on 44 index-linked gilt versus 44 conventional gilt Spread (bps) /11/13 04/02/14 04/05/14 04/08/14 04/11/14 04/02/15 04/05/15 04/08/15 04/11/15 Relative z-spread (44 linker minus 44 gilt) Solvency II flows and execution of swaps Solvency II prices liabilities with respect to a risk free rate which is closest to swaps. Hence, insurers have been closing out certain gilt positions and replacing them with swaps. Now, this is a popular factor to attribute swap spread changes to but we should bear in mind that longer maturity swap spreads should be less impacted by insurers whose liabilities are shorter dated. Furthermore, it would seem odd for a relatively sophisticated group of investors to be making very sudden moves to their asset allocation at the last minute. Finally, swap receiving - which generally refers to investors executing (receive fixed) interest rate swaps - is something that would impact swap spreads. Where there is greater demand in this area compared to gilts, swap spreads will rise as a result. Again, there is anecdotal evidence for this activity. Not just a UK story It is worth noting that a similar pattern is visible in the US at the moment (albeit Europe is not showing the same signs), Figure 5 below shows that US swap spreads have also increased dramatically over 15 and in particular over the last month. The factors behind this are similar to the UK, except for the Solvency II flows which do not apply to US insurers. One particular feature in the US over the past month has been a surge in corporate bond issuance. Many of these bonds are swapped into floating rate debt by the issuer, and this causes a large demand for swap receiving, and hence makes swaps expensive relative to treasuries.

6 NOVEMBER 15 LGIM LDI FUNDS 6 Figure 5. US versus UK swap spreads 50 Spread (bps) /11/14 05/01/15 05/03/15 05/05/15 05/07/15 05/09/15 05/11/15 UK 30-year swap spread Where do we go from here? US 30-year swap spread Short term In the short term, we would observe that swap spreads have moved quickly higher over the last month. We believe that the same forces that have driven this move (and discussed above) are still in play, which means that our central scenario is for swap spreads to continue in the same direction, particularly as we approach the year end. However, we recognise that there is much uncertainty given the very swift changes in markets and possibility for a snap back. Hence, this is not an area where we would implement material positions. Repo and funding Even if repo gets more expensive it is hard to see vast pension fund selling of gilt positions because of the yield benefit compared to the (repo) funding cost. Of course we may see pension funds looking to gain leverage in other areas namely equities or credit. That said, if repo is expensive, we would not expect other forms of leverage in other asset classes to be persistently cheaper. Although regulators have stuck to their guns around making leverage more expensive would they really want to see a genuine crisis in these markets? Separately there is always the possibility of innovative solutions being developed if repo funding costs reach a certain level. Non-banking players could come in and it would be very interesting to see if there is ever a shift in liquidity to gilt Total Return Swaps, which theoretically present some advantage to banks compared to repo because of their contract for difference nature (rather than loan), meaning they could have a reduced effect on the balance sheet. Who is the marginal buyer of swap spreads? As levels become more attractive we should also consider who will be buying. Natural candidates include so called Real Money (for example, traditional active bond funds) or Fast Money (the hedge funds of this world). At the moment it is quite possible that hedge funds would be following momentum signals, thereby helping swap spreads go higher. In the longer term they may come into these positions but the hurdle rates to get involved are higher than historically because these players have to pay more for leverage. Furthermore, as the swap spread is now outside its recent trading range we assume that there is likely to be less switching activity from swaps to gilts, as many investors are already long gilts with little powder remaining. Longer term Despite elevated funding costs on gilts, we believe that the current yield pick-up available on gilts versus swaps more than compensates for this and so continues to make them an attractive way to hedge liabilities in the medium term. It is also worth bearing in mind that in the longer term, deleveraging flows from equities (when they ve outperformed) or contributions into matching assets should mean that pension funds do not need to finance their gilt holdings through repo for the full maturity of the gilt. Therefore gilts will likely continue to be the funded instrument of choice for pension funds (combined with corporate bonds). This should oppose very high swap spreads over longer time horizons. However, we expect the dominant drivers of high spreads, namely Solvency II fuelled swap demand and higher repo costs, to represent a structural change. This coupled with the anecdotal evidence of reduced range trading of swap spreads means there is now less of a mechanism to keep spreads in a range. We therefore believe that swap spreads could increase further. Wrap up Conventional gilt yields are well below 3% (and closer to 2.5%) whilst index-linked gilt yields are well below 0% (and closer to -1%). It is hard to argue that this is an unloved asset class, just that swap yields have fallen even more than gilts. For pension funds hedging their liabilities with gilts, recent developments are unlikely to keep them up at night as they continue to match their (generally gilt-based) liability basis. So although swap spreads have increased, we should not lose sight of the hedging benefit which gilts have continued to offer. In our view, generally conservative leverage levels at pension funds should also ensure that there are no immediate issues.

7 NOVEMBER 15 LGIM LDI FUNDS 7 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 -year swap rates will be in 3 years time. This is different from today s -year swap rate. 3yy ATMF+1% premium: This is the premium that a scheme receives, up-front, if it sells a 3yy 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 3yy 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 -year swap rates are higher than 2.5%, then the scheme would either enter into a -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 -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. 3yy 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 3yy receiver swaption using all of the premium received from selling the 3yy 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 -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 -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 -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% -year swap rate in 3 years Unhedged Position Position with Zero-Cost Collar

8 NOVEMBER 15 LGIM LDI FUNDS 8 Equity options educational refresher Equity options educational refresher Implied volatility: FTSE Volatility Index, an index of the short-term volatility in the FTSE (over the next 30 days) as implied by the pricing of FTSE 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 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% 1% 110% % 90% 80% 70% % % 80% % 1% 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 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% 1% 110% % 90% 80% 70% % Zero-cost 90/70 put spread collar payoff (for illustrative purposes only) 140% 130% 1% 110% % 90% 80% 70% % 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 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 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.

9 NOVEMBER 15 LGIM LDI FUNDS 9 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 % 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. 15 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. M0639