LDI Monthly Wrap. Key Events and Data. Market conditions. Zero Coupon Swap Interest Rates. Zero Coupon RPI Swap Rates

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1 MARCH 2015 LGIM SOLUTIONS GROUP LDI Monthly Wrap. Monthly market update Robert Pace LDI Strategist Anne-Marie Cunnold LDI Strategist Robert and Anne-Marie focus on LGIM s LDI strategy and are responsible for thought leadership and product innovation for the LDI area, highlighting opportunities for our LDI offering to grow and change with our clients needs. Market conditions Yields bucked the recent trend in February, increasing pretty dramatically (by around 35-45bps) to end the month around the levels seen at the start of the year. There were a number of contributing factors to the sharp move upwards and general risk-on sentiment, including stronger economic data out of the UK and US, and a partial agreement between Greece and its so-called Troika of creditors (the IMF, ECB and EU) that avoided immediate default by the indebted nation. Moves higher in yields were generally parallel across all maturities longer than ten years. Gilt and swap yields moved broadly in step during February, with the relative difference between the two only changing by around c2-3bps over the month at longer maturities. Inflation rates were helped higher by the moves in nominal rates and a slight recovery in the price of oil, with Brent Crude up 18% during February at c$ Real yields continued to retrace as the month continued; ending February at around -65 to -70bps at longer maturities, some way off the lows seen in mid-january. The more risk-on sentiment during the month helped a number of global equity markets approach or reach new record highs, including the FTSE 100 and S&P 500. Key Events and Data UK: The release of the Bank of England s (BoE) Quarterly Inflation Report saw the Bank slightly upgrade UK economic growth forecasts and indicate that, in the short term, CPI inflation is likely to print below zero. Interestingly, BoE governor Carney was quick to point out that the committee were, to an extent, looking through the impact of the temporary fall in oil prices on inflation prints, and emphasised that the market was perhaps pricing the first hike in base rates too far into the future. Countering these points was the statement that the Bank no longer sees 0.5% as being a lower bound for interest rates where monetary policy still has an effect. The BoE MPC minutes showed that the vote remained at 9-0 to maintain interest rates at current levels, with some members of the committee describing the decision to vote for a rate hike as finely balanced. Interestingly, one committee member viewed it just as likely that the next move in Bank rate could be lower. Market conditions Zero Coupon Swap Interest Rates Zero Coupon RPI Swap Rates Government Bond Yields relative to Swap Yields (bps) Other Markets January 2015 February 2015 Change* 10 Year 1.46% 1.92% 0.46% 30 Year 1.79% 2.24% 0.45% 30 Year Minus 10 Year 0.33% 0.32% -0.01% 10 Year 2.73% 2.93% 0.20% 30 Year 3.17% 3.34% 0.17% 30 Year Minus 10 Year 0.44% 0.41% -0.03% 2022 Gilt Z-Spread Gilt Z-Spread ILG Z-Spread ILG Z-Spread VIX (%) Month LIBOR (bps) SONIA (bps) FTSE (Explanation of indicators on page 8). *Figures may not total due to rounding.

2 MARCH 2015 LGIM SOLUTIONS GROUP 2 Monthly market update continued... On the data front, the unemployment rate came in lower than expected, falling to 5.7% (from 5.8% expected). Similarly, CPI inflation fell to the lowest on record, with consumer prices increasing only 0.3% over the last year (vs. 0.4% YoY expected) and RPI inflation falling to 1.1% YoY (vs. 1.3% expected). US: Employment data in the US (released in February) showed the economy added 257,000 jobs in January, more than the c230,000 expected by the market. Upward revisions of previous data prints were also encouraging, with three month average job creation rising at the fastest rate since CPI inflation came in as expected at -0.1% YoY, whilst the core print (stripping out the effects of more volatile prices such as energy) came in slightly higher than expected. The second reading of US Q4 GDP also surprised on the upside at 2.2% annualised, though was revised down from an initial 2.6% annualised. Europe: Greece saw its borrowing costs rise as the ECB announced it would stop accepting Greek government bonds as collateral for certain types of loans offered by the bank. In principle, an agreement to extend the indebted nation s current bailout terms for a further 4 months was agreed between Greece and its lenders, subject to the provision of detailed reform proposals from the Syriza government to the Eurogroup. Whilst the immediate danger of the economy being unable to pay creditors abated somewhat, numerous and significant hurdles remain for both sides to renegotiate a more permanent solution. Q4 Eurozone GDP came in slightly ahead of expectations at +0.9% YoY (vs. +0.8% YoY expected), with Germany driving matters. Supply There was limited supply of note for LDI investors during February. The Debt Management Office (DMO) auctioned 1.2bn of the 2024 index-linked gilt at a real yield of -1.02%. There was also an issue of 1.75bn of the 2045 conventional gilt at a yield of 2.36%.

3 MARCH 2015 LGIM SOLUTIONS GROUP 3 In Focus Protection on your inflation protection For those looking at long-term interest rate and inflation prospects, it is fair to say that the prospect of hedging inflation has generally been more desirable than hedging interest rates. However, inflation-only hedging in isolation can increase funding level volatility, which means that going a long way beyond a scheme s interest rate hedge has been less attractive. In focus this month is a recap on the inflation interest rate dynamic and a few options for dealing with these consequences. Inflation fundamentals Inflation swap rates remain low by historical standards, albeit they have bounced slightly from the recent lows (c.3.2% towards the end of January 2015), accompanying nominal yields higher. Figure 1 shows the current position: Figure 1: Inflation swap rates ZC RPI swap curve 1yr RPI swap forwards Long term inflation estimate What is interesting for pension funds is the fact that these lows by historical standards also coincide with arguably favourable conditions on more fundamental long-term estimates. Building up from a 2% CPI target with some slippage we have remarked in the past how inflation expectations upwards of 3.5% can be justified. Figure 1 shows how the one-year forward rates compare to 3.5%. We leave the nuances of short-term inflation prediction here. An alternative path to inflation hedging In fact, for those with capital to invest, synthetic break-even inflation offers even lower entry levels as the Figure 2 demonstrates: Figure 2:Synthetic break-even inflation ZC RPI swap curve ZC synthetic break-even inflation By synthetic break-even inflation, we are talking about the combination of an index-linked gilt position with offsetting interest rate swaps that remove the interest rate sensitivity but retain the inflation sensitivity. The reason for the large differential therefore is that gilt inflation is lower than swap inflation and nominal gilts are higher yielding than swaps. The interaction between inflation and long-term interest rates The difficulty for those investors looking at longer-term value metrics has been (and will continue to be) that price can be driven by short-term trends. Where inflation is concerned, that means the push and pull effect of movements in nominal yields. Figure 3 shows how it is relatively common for inflation to move lower (or higher) on the back of nominal moves. Inferring too much from the middle of the period is harder given the regulatory discussions happening at that time around RPI and potential changes to the formula effect.

4 MARCH 2015 LGIM SOLUTIONS GROUP 4 Figure 3: Interest rate and inflation swap /03/ /03/ /03/ /03/ /03/ /03/ yr ZC Interest rate swap 10yr ZC Inflation swap At one level this demonstrates a point often made about inflation only hedging, namely that it can counter intuitively increase risk when assessed from a Value at Risk perspective. For example, consider two common scenarios: 1. Where yields increase it would be expected that inflation swap rates also increase 2. Where yields decrease it would be expected that inflation swap rates also decrease In scenario 1: - An unhedged position would benefit from the rise in yields - By adding inflation only hedging, that benefit may be more pronounced In scenario 2: - An unhedged position would suffer from the fall in yields - By adding inflation only hedging, that increase in deficit may be more pronounced Hence, even though inflation hedging is a hedge of actual future cashflows and market conditions may be attractive, there can often still be some reticence about going too far beyond the level of interest rate hedging. The added funding level volatility is undesirable. Protecting against the interest rate minefield How can this be mitigated? We discard the use of interest rate swaps as the general purpose of the inflation hedging is because the interest rate element is deemed unattractive. What that does leave is the possibility of using swaptions as something that might be cheaper than using interest rate swaps but still offer some protection against big swings in interest rates. The premise or beliefs needed to buy receiver swaptions would be that: - Interest rates are more likely to rise than fall - Paying an amount of premium for a receiver swaption would cost an amount of 2m say (this is a fictional number) - The expected rise in interest rates is likely to result in a swap MTM which is sufficiently worse than - 2m to make the premium worth paying Our starting point would be a swaption with a swap whose underlying PV01 is the same as that of the inflation swap. However, the delta adjusted PV01 would be much less than this say 30% or 40%. The swap underlying the swaption would generally be best executed at a similar maturity to the inflation hedging but given liquidity constraints after 30 years (in swaption space) there would need to be some compromise here. The strategy can be extended to include payer swaptions with the width of the collar (the difference between receiver and payer strikes) chosen to give the right balance between risk reduction and benefitting from rising inflation swap rates.

5 MARCH 2015 LGIM SOLUTIONS GROUP 5 Market data Interest rates Inflation Rate (%) Y Zero Coupon Interest Rate Swap 30Y Zero Coupon Interest Rate Swap Rate (%) Y Inflation Swap 30Y Inflation Swap Interest rate curve Inflation curve Rate (%) Rate (%) Y - 10Y Zero Coupon Interest Rate Swap 30Y - 10Y Inflation Swap Z-spreads Relative Z-spreads (IOTA) Z-Spread (bps) IOTA (bps) Gilt 2022 Gilt 2042 ILG 2022 ILG 2042 IOTA 2022 IOTA 2042 Short-term interest rates and funding February 2014 January 2015 February 2015 SONIA 0.39% 0.42% 0.44% 3-Month LIBOR 0.52% 0.56% 0.56% 6-Month LIBOR 0.61% 0.68% 0.68% UK Gilt Total Return Swap: 6 Months 0.57% 0.70% 0.64% UK Gilt Total Return Swap: 1 Year 0.60% 0.72% 0.74% 6-Month Gilt Repo 0.53% 0.65% 0.60% 1-Year Gilt Repo 0.56% 0.72% 0.72% Note: TRS and repo pricing is transaction-based where possible, and can vary materially by bank

6 MARCH 2015 LGIM SOLUTIONS GROUP 6 Swaptions educational refresher Interest rate swaption markets February 2014 January 2015 February Y/20Y ATMF+1%: Premium 1.89% 3.67% 3.10% 3y/20y zero-cost collar +1%/ Y 1.06% 0.77% 0.91% ATMF (implied 20Y rate in 3Yrs) 3.70% 1.86% 2.35% HeatMap: zero-cost collar +1%/-Y Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.73% 0.89% 0.96% 1.01% 1.10% Option tenor 2y 0.75% 0.91% 0.97% 1.01% 1.09% 3y 0.73% 0.85% 0.89% 0.91% 0.96% 4y 0.73% 0.85% 0.89% 0.91% 0.94% 5y 0.74% 0.85% 0.88% 0.90% 0.92% 28 February 2015 The collar heatmap above 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. Swaption: 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 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). Swaption collar: impact (for illustrative purposes only) 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 Key risks The use of derivatives may expose schemes to additional risks. Please see the Key Risks information on page 8.

7 MARCH 2015 LGIM SOLUTIONS GROUP 7 Equity options educational refresher Equity market - FTSE 100 February 2014 January 2015 February Y 90% put: cost 3.11% 4.15% 3.45% 1Y 90/70 put spread: cost 2.50% 3.12% 2.70% 1Y zero cost 90/70 put spread collar: "X" % % % FTSE 100 Implied volatility 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.

8 MARCH 2015 LGIM SOLUTIONS GROUP 8 Supporting material Explanation of indicators In our heatmap table on page 1, we use historic volatilities of the various market indicators over a onemonth time period to highlight significant moves. We mark an indicator in dark green or red if the change in the value of the indicator is larger than a 1 in 10 event, light green or red if the change is a 1 in 5 event and blue for no significant change. Green represents an up movement over the month and red represents a down movement over the month. 1 in 10 upward move 1 in 5 upward move No significant move 1 in 5 downward move 1 in 10 downward move The swaption collar heatmap on page 6 uses the same colours and levels of significance, but shows how the most recent value compares to the last 12 months worth of weekly data. Gilt Total Return Swaps (TRS) In our Short-term interest rates and funding table on page 5, 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 4. 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 5. 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. 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 - LDI Strategist Anne-Marie Cunnold - LDI Strategist robert.pace@lgim.com anne-marie.cunnold@lgim.com +44 (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. M0320