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

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1 JULY 2016 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 Of course, the referendum took centre stage with markets very much affected by opinion polls in the run up, first pricing a move to Brexit, then back to remain until finally the exit vote fed fully into pricing. This gave us some clues about potential moves in advance of the vote concluding and largely speaking expectations were borne out in bond land Nominal and real yields exhibited very similar moves lower and largely identical by tenor as well. This went somewhat against conventional wisdom where the 10-year point might have been expected to move by more than its longer-dated counterparts. Finally, at the really short end, yields tumbled as markets priced in rate cuts very close to zero Inflation was led higher by the impact of a weaker sterling at shorter maturities but fell at longer maturities albeit not that far considering the size of the falls in nominal yields With more quantitative easing being priced in and more demand for gilts and indexlinked gilts z-spreads were again lower on the month The FTSE was resilient in the aftermath given its diverse properties and a significant percentage of earnings being non-sterling. The index ended the month marginally higher Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 30 June 2016 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 0.81% 1.73% 1.52% Gilt Real Yields -1.65% -1.30% -1.43% Gilt Breakeven Inflation 2.46% 3.04% 2.95% ZC Swap Rates 0.99% 1.22% 1.08% RPI Swaps 3.03% 3.13% 3.06% Gilt Z-Spreads (vs. 6mL) Linker Z-Spreads (vs. 6mL) IOTA (Relative z-spread) Key Events and Data Equities, Volatility & Credit Current Monthly Change FTSE 6, S&P 500 2, y30y Swaption Vol 68.8% +23.9% FTSE Implied Vol 20.4% +0.4% CDS - 10y itraxx (bps) CDS - 10y CDX (bps) m LIBOR (bps) Region Period Actual Consensus Prior Comments US non-farm payrolls US May 38, , ,000 US GDP UK Q % 0.4% 0.4% UK Base rate decision UK Jun 0.5% 0.5% 0.5% UK CPI UK May 0.3% 0.4% 0.3% Annual Inflation UK RPI UK May 1.4% 1.5% 1.3% Annual Inflation UK unemployment UK 3m to Apr 5.0% 5.1% 5.1% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 9 June 2016 Auction 0 1/8% Index-linked Treasury Gilt % June 2016 Auction 4¼% Treasury Gilt % June 2016 Auction 1½% Treasury Gilt % 1.60

2 JULY 2016 LGIM LDI FUNDS 2 Market Data Interest rates Inflation Rate (%) Rate (%) Y ZC IRS 30Y ZC IRS 10Y Inflation Swap 30Y Inflation Swap Interest rate curve Inflation curve Rate (%) 0.2 Rate (%) Y - 10Y Zero Coupon Interest Rate Swap Y - 10Y Inflation Swap Z-spreads Relative Z-spreads (IOTA) Z-Spread (bps) (20) IOTA (bps) (40) Gilt 2024 Gilt 2045 Linker 2024 Linker 2044 (10) IOTA 2024 IOTA 2045

3 JULY 2016 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding SONIA 0.39% 0.45% 0.44% 3-Month LIBOR 0.58% 0.59% 0.56% 6-Month LIBOR 0.74% 0.74% 0.68% UK Gilt Total Return Swap: 6 Months 0.61% 0.84% 0.65% UK Gilt Total Return Swap: 1 Year 0.80% 0.85% 0.70% 6-Month Gilt Repo 0.60% 0.77% 0.63% 1-Year Gilt Repo 0.83% 0.81% 0.68% 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 3Y/20Y ATMF+1%: Premium 2.82% 2.97% 3.54% 3y/20y zero-cost collar +1%/ Y 1.06% 1.13% 1.02% ATMF (implied 20Y rate in 3Yrs) 2.54% 1.85% 1.36%, Bloomberg L.P. Zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.59% 1.00% 1.04% 1.05% 1.06% 2y 0.67% 1.04% 1.05% 1.05% 1.05% 3y 0.67% 1.00% 1.01% 1.02% 1.03% 4y 0.83% 1.02% 1.02% 1.02% 0.92% 5y 1.00% 1.01% 1.02% 1.02% 0.74% The heatmap colours will return in the next issue of the LDI monthly Wrap, Bloomberg L.P.

4 JULY 2016 LGIM LDI FUNDS 4 Market Data UK (FTSE ) 1Y 90% Put: cost 3.86% 4.48% 4.70% 1Y 90/70 put spread: cost 3.01% 3.33% 3.47% 1Y zero cost 90/70 Put Spread Collar: "X" % % % FTSE Implied Volatility FTSE Forward/Spot US (S&P 500) 1Y 90% Put: cost 3.93% 3.98% 4.25% 1Y 90/70 put spread: cost 2.92% 2.86% 2.99% 1Y zero cost 90/70 Put Spread Collar: "X" % % % S&P 500 Implied Volatility S&P 500 Forward / Spot Europe (Euro Stoxx 50) 1Y 90% Put: cost 5.49% 5.88% 6.41% 1Y 90/70 put spread: cost 4.14% 4.08% 4.40% 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 UK 1Y % Call 4.78% 5.11% 5.24% 1Y 105% Call 2.70% 2.93% 3.06% US 1Y % Call 5.89% 5.85% 5.90% 1Y 105% Call 3.41% 3.30% 3.35% EUR 1Y % Call 7.00% 6.58% 6.87% 1Y 105% Call 4.86% 4.47% 4.75%, 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 % strike in the UK (as a percentage of spot) will be different to a % strike in the US when related to the strike as a percentage of forward. Implied volatilities are based off short maturity options (approximately 30 days) namely VFTSE, VIX and V2X for UK, US and Europe respectively.

5 JULY 2016 LGIM LDI FUNDS 5 In Focus Post-referendum musings The world hasn t ended (yet) but markets have certainly moved and anyone watching the news regularly probably feels as though they are only a short crash course away from being a currency trader. In focus this month (with a little help from our weekly LDI Brief) we have a few charts to complement the usual markets section and also some thoughts on risk management following the event. As we noted in our pre-referendum note risk management frameworks held up well as did many (but not all) of our advance predictions. Is that yield real Our first observation is that in general yields experienced a fairly parallel shift downwards across the curve. The slight exception to this was short-dated real yields which were impacted by the increase in inflation expectations (visited in more detail below). Below we show the 2065 index-linked gilt yield syndicated in the week commencing 25 July which, having followed conventional yields down is off the lows but still likely to make a syndication record. Figure index-linked gilt real yield Real yield (%) /02/ /03/ /04/ /04/ /05/ /06/ /06/ /07/2016 UKT IL 0.125% 22-Nov-2065 analytics, Bloomberg L.P. With such a large move in yields and the change in likely direction of Bank of England policy, we suggest clients should consider the appropriateness of trigger levels, particularly interest rate triggers. There is still much uncertainty in what the eventual outcome will look like, regarding the ultimate level of interest rates. Nonetheless, clients should note that if their current interest rate trigger levels are maintained, the likelihood of these triggers being reached may have fallen significantly. Specifically there are significant risks that interest rates may fall further e.g. due to potential rate cuts and even further quantitative easing by the Bank of England if we do see a slowdown in UK economic growth. Clients should bear this in mind when considering whether to hedge at current levels, or delay further interest rate hedging. Britain against the world This isn t next year s referendum but instead a chart showing how UK yields compare to Germany and the US. We can see here that the July rate (no) decision from the BoE went pretty much unnoticed whilst the bigger picture is that global yields fell post Brexit (marked by the dotted line) but this has (unsurprisingly) been more pronounced in the UK. A particularly tight trading range of relative bond yields from the start of the year is now about 30bps lower (i.e. gilts have generally fallen by about 30bps relative to both US and Germany). So, all eyes to August and any hints on QE and other potential alternative forms of policy easing. Figure 2. Yield difference between gilts and US treasuries/german bunds Yield difference (%) /12/ /01/ /02/ /03/ /04/ /05/ /06/2016 Gilts minus USD Treasuries Gilts minus German Bunds analytics, Bloomberg L.P.

6 JULY 2016 LGIM LDI FUNDS 6 Inflation or deflation The chart below shows two snapshots of the inflation swap curve and we can see that whilst shorter dated inflation has risen, longer dated inflation swap rates have gone down and currently sit around the 3% level. By way of reminder a weaker currency is expected to provide some inflationary pressure due to higher import prices with more pounds needed to buy an item priced in a different currency. Against this, higher inflation should ultimately act to reduce real incomes and consumption thereby providing a deflationary effect. This narrative seems to have broadly played out in the reaction of market. At longer maturities the quantitative easing rumours would be expected to initially compress break-even inflation on the basis that gilts are bought but not index-linked gilts. Figure 3. Inflation swap curve comparison 8 July versus 23 June 3.5 Inflation swap rate (%) GBP UK RPI ZC 08-Jul-2016 GBP UK RPI ZC 23-Jun-2016 Fiscal risks or saved by QE? Any concerns about overseas investors moving out of gilts have certainly been put to one side for the time being. Demand for gilts has been dominating the spread between gilt yields and swap yields whilst any concerns about looser fiscal policy and greater future bond issuance does not yet seem to be impacting matters. Figure 4. Gilt yields compared to swap yields 80 analytics, Bloomberg L.P. Z-spread (bps) /07/ /09/ /11/ /01/ /03/ /05/ /07/2016 UKT 5% 07-Mar-2025 UKT 3.5% 22-Jan-2045 analytics, Bloomberg L.P. What else? We believe that the referendum result is credit negative for UK banks, due to weaker medium-term growth and potentially losing the ability to passport services into the EU following exit. However, the probability of default for UK banks appears very low given their strong funding and liquidity profiles as well as their strong capital positions. The results of the recent UK bank stress test showed the resilience of the UK banking sector to macro-economic and asset stresses. In terms of rating implications, we do not expect any near-term rating actions. Over the medium-to-long term, any rating actions are likely to depend on factors such the size and duration of the impact on the economy, asset prices, unemployment and interest rates. Having a diverse range of counterparties on the panel including central counterparties consequently makes a lot of sense. We reviewed each client s collateral position in advance of the Brexit vote (using our VaR methodology managed by our Independent Risk team). All clients held sufficient collateral above their critical level, with many holding collateral above their optimal level. For those clients near their critical collateral level, they were contacted and all provided additional collateral to their portfolios, to ensure there was a sufficient buffer. LGIM continues to manage the cash level within each mandate within the optimal and critical cash levels which we monitor internally. If additional cash is required for margin purposes, as usual we are raising this using gilt repo and this market continues to operate well, with good liquidity. This robust framework applies across the derivative landscape (swaps, repo, synthetic equity, credit derivatives and FX) including liquidity considerations.

7 JULY 2016 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 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

8 JULY 2016 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% 120% 110% % 90% 80% 70% 60% 60% 80% % 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 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% % 90% 80% 70% 60% Zero-cost 90/70 put spread collar payoff (for illustrative purposes only) 140% 130% 120% 110% % 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 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 JULY 2016 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 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. M1048