This is Non-Independent Research, as defined by the Financial Conduct Authority. Not intended for Retail Client distribution.

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1 This is Non-Independent Research, as defined by the Financial Conduct Authority. Not intended for Retail Client distribution. This material should be regarded as a marketing communication and may have been produced in conjunction with the NatWest Markets trading desks that trade as principal in the instruments mentioned herein. All data is accurate as of the report date, unless otherwise specified. NatWest Markets is a marketing name of The Royal Bank of Scotland plc. Desk Strategy European Macro Strategy 26 May 2017 GBP Rates Long-end swap spread tightening to continue. Buy 2045 s on ASW. We review the key considerations likely to be made by a pension fund when looking at gilt vs. swap liability hedging. Using gilt based hedging brings the flexibility of being able to post cash or gilt collateral as variation margin, but comes with the risk of regular repo refinancing. If the benchmark is gilts based, gilt repo leads to lower volatility as well as a higher yield than swaps. In contrast, for a swap-based benchmark, gilt repo poses additional risk through swap spread volatility. Regulation has surpassed sovereign credit risk and fiscal metrics as the key driver of long-dated swap spreads over the past 18 months. Gilt repo has been gradually cheapening since early 2016, but the emergence of repo facilitators outside of the banking system means this is likely to continue. Data shows repo is now the most widely used derivate instrument for European pension funds. According to the Mercer European Asset Allocation Survey, Government bond use surpassed swap activity in Scope for continued gilt outperformance. Looking at current swap spreads and factoring in the cost of funding together with repo roll risk and credit risk, suggests a breakeven level of ~8bp for gilt yields over swaps. Given recent volatility, however, we think there is a risk of an overshoot before stabilisation is achieved. An illustrative look at swap vs. gilt allocation of an active LDI manager also suggests there is further room for Gilt outperformance. Trade: Buy UKT 3.5% 2045 vs. a matched maturity swap. Enter at 33bp, target 13bp and place a stop at 43bp. 30y gilts cheap vs. swaps on the basis of improving UK fiscal metrics Source: NWM, Bloomberg Mar-00 Mar-05 Mar-10 Mar Strategists UK net debt (% GDP, inv) 30y swap spread, rhs Simon Peck UK Rates Strategy simon.peck@natwestmarkets.com Robin Thompson Head of Insurance & Pension Solutions robin.thompson@natwestmarkets.com In February 2016, long-end swap spreads widened beyond levels seen during the financial crisis. At their peak on 29 th February 2016, 30y Gilt yields were nearly 80bp higher than swaps, but unlike the crisis period, the fundamental drivers of sovereign credit risk and the UK government borrowing were not to blame. Over the past eighteen or so months, one, if not the key driver of long-end UK swap spreads has been bank regulation. As a result of Leverage Ratio based capital requirements, the implication is a ~50bp charge for Gilt repo 1. Although this was not fully reflected in repo transaction charges, the cost of repo financing gradually increased in the period ahead of the 2018 binding date, from flat to + 40bp. For market participants comparing the use of swaps vs. Gilt TRS or leveraged gilts, the additional cost of repo is an important consideration. An additional 40bp of yield would be required to make long-end gilts as attractive as they looked in 2014 compared to swaps. The emergence of alternative repo providers outside of banks has cheapened repo rates and subsequently seen long-end swap spreads tighten. We believe repo can cheapen further and consequently, we look for a further outperformance of gilts vs. swaps in 30y. 1 Assuming banks target a leverage ratio of 4% and have a 12% cost of capital, the charge is 48bp. Bloomberg: RBSR<GO>

2 1) Pension fund financing considerations From a pension fund perspective, the chart below compares the cost of liability hedging with swaps and gilt repo. Adjusting the swap spread for the difference in these costs allows for a fairer comparison of the two hedges. 6M LIBOR, Gilt Repo & Reverse Repo spreads to Source: Bank of England, Bloomberg, NatwestMarkets illustrative gilt repo level. Sell/Buyback = borrow money illustrative gilt reverse repo level, Buy/Sellback = lend money 6m LIBOR -20 Mar-2013 Mar-2014 Mar-2015 Mar-2016 Mar-2017 While historic time series of 6M LIBOR vs. exist, data regarding the funding spread (repo vs. 6M LIBOR) is more difficult to obtain post 2013, when the BoE time series finishes. Therefore, in the chart we have a simplified interpolation on a few data points, using BoE data for the starting levels in 2013, reaching a maximum of + 45bp in 2016 and reducing by ~10-15bp since then. Currently, the financing costs of the two strategies (offered repo rates are close to LIBOR) are very similar at ~50bp, the 6M LIBOR level, meaning that a higher yield is obtained through a gilt repo hedge when compared to a swap hedge. The chart also shows approximate reverse repo levels, indicating that the reduction in the repo rate relative to has occurred due to cheaper funding becoming available, rather than due to banks lowering their Leverage Ratio charge. Additional considerations when comparing swaps and gilt repo hedging: Funding maturity. Repo needs to be refinanced regularly (e.g. every 6 months) and is therefore subject to future potential financing squeezes. Inherently, the swaps-based hedge has less funding risk, but the assumption that repos need to be rolled for years ignores the pension journey plan. This may assume the scheme is fully funded in ~10 years. At that point the pension fund would plan to be in cash assets, e.g. gilts, and swap spread volatility may favour gilt repo. Additional costs of the swap hedge. Under a cash & gilts CSA, banks will try to pass on the funding costs of the embedded repo associated with gilt collateral, as well as derivative Leverage Ratio costs. With clearing or a cash-only bilateral CSA, the LDI manager will have costs associated with entering a gilt repo to generate cash collateral, when variation margin needs to be posted. If rates sell off sharply, cash is required an undesirable position for a pension fund to be in. That is to say the cost of turning collateral into cash must be taken by the investor directly or indirectly, reducing the attractiveness of swaps. Risk-free Rate (RFR) and reform. The BoE working group on sterling riskfree reference rates recently concluded that the best candidate is OIS, but there is still some uncertainty around the future of the LIBOR swap market. Credit Risk. As the swaps are collateralized, there is no credit risk, whereas the gilt hedge contains some credit risk and therefore additional return should be required to compensate. For context, 6m UK sovereign CDS has traded between 3bp and 15bp over the last year. Page 2/7

3 The liability benchmark. If the benchmark is gilts based, the gilt repo leads to lower volatility as well as higher yield than swaps. In contrast, for a swap-based benchmark, gilt repo poses additional risk through swap spread volatility. A Worked Example: fair value = gilts yields 8bp over swaps If we look at hedging a liability at the 30y horizon, with gilt repo or swaps, we start by comparing the yields through the swap spread. We then add in the funding leg, through the spread to. By combining these two considerations together, we are then able to create a fair comparison of hedging with swaps or gilt repo. The table below shows how this has evolved over the last year. Illustrative example of gilt vs. swap hedging costs (current vs. 1y ago) ASW(pick up for gilt yields over swaps) Repo 6M LIBOR Funding advantage for cash vs. LIBOR Total carry pick up for gilts vs. swaps 23-May bp +25bp +22bp -3bp 35bp 23-May bp +40bp +31bp -9bp 51bp Source: Natwestmarkets, Bloomberg The ASW spread that results in flat carry, i.e where there is no incentive to prefer gilts or swaps from a carry perspective is approximately 3bp. We expect this to fall further as price pressures ease on repo. To this breakeven level we should adjust for sovereign credit, repo roll risk and benchmark preference. The result is an implied ASW spread of 8bp. Pricing in risk factors brings 30y ASW fair-value to 8bp, NWM estimate Breakeven carry ASW Repo roll Credit Benchmark preference +3bp +7bp +8bp -10bp 8bp Source: NatwestMarkets 2) Benchmarks and derivative use The end goal of the pension scheme, i.e. self-sufficiency (SS), buy-in or buy-out is generally expressed as a spread to gilts, swaps or even a combination of the two, with technical provisions (TP) usually being expressed in the same way. This will then be translated into a benchmark for the LDI manager, i.e. a gilts-based or swaps-based benchmark. Given the long duration nature of the liabilities, the choice can make a large difference to the valuation of the liabilities as swap spreads change. Consultants we have spoken to generally suggest TP and SS benchmarks are nearly always based on gilts, but due to swaps being the instrument of choice when LDI first became popular, many early LDI mandates were swap-based. The 2013 KPMG LDI Survey referenced 50% of schemes using gilts as a benchmark and ~25% using swaps. Recent conversations with consultants suggests that 75%-90% may now be on gilt benchmarks with the majority of switching, where it has occurred, happening last year. Inevitably when swap yields were above gilt yields, pre-crisis, there was a Page 3/7

4 natural bias towards swap-based benchmarks. Since, the polarity has reversed and there is a similar tendency towards gilt-based benchmarks. When swap yields are below bond yields, the active LDI manager with a swap-based benchmark is also likely to choose to invest in gilts / gilt repo to outperform. Type of derivative used by European pension schemes (as a % of those using derivatives) Source: Mercer European Asset Allocation Survey, % 80% 70% 60% 50% 40% 30% 20% 10% 0% Government Bond Repos Interest Rate Swaps Inflation Swaps Government Bond TRS Swaptions Government bond repo became the most widely used derivate instrument in 2015 Source: Mercer European Asset Allocation Survey, % 80% 60% 40% 20% Government Bond Repos Interest Rate Swaps The above chart shows how this trend has developed since Though this looks across Europe at the type of derivatives used by pension schemes active in derivatives, the survey is dominated by the UK (~56%). The use of derivatives has broadly increased since 2012 and in 2015 Repo surpassed interest rate swaps as the most widely used instrument of those schemes active in derivative space. Such a trend corroborates with the higher yields on offer in gilts vs. swaps over this period and the move towards gilt-based LDI benchmarks. 3) Why is Gilt repo cheapening? Reverse repo and repo rates have both reduced relative to over the last 6 months. There appear to be a number of reasons that might have led to the reduction in gilt financing costs from the 2016 highs, including: 0% Non-Leverage Ratio constrained banks. Banks which are significantly above their Leverage Ratio target, and are therefore only concerned with the negligible RWA cost (<1bp) have been able to provide cheaper gilt repo. Also, other banks which have been Leverage Ratio constrained are learning to manage their capital better. Non-bank solutions. The evolution of the regulatory environment has seen the development of alternative approaches to repo financing from non-bank counterparties, with peer-to-peer, money-market (liquidity) funds or cash-rich corporates having become increasingly active in the repo market. We also note that other entities such as LCH (with 60bn cash and cash equivalents as of end 2016) are likely to be significant drivers of this. Leverage Ratio-friendly bank solutions. Banks are creating solutions which provide gilt performance without the full Leverage Ratio impact. These include netting trades, such as netted repo, agency repo and TRS without the initial exchange. The chart below shows the cash flows on the TRS without initial exchange trade. On the trade date, the client enters into a TRS to gain exposure to the full risks and rewards of the bond. During the transaction, the client pays a semi-annual fee ( + spread) based on the initial market value of the bond and receives all coupons. Upon maturity of the TRS, the client purchases the bond at a pre-agreed price. Alternatively, Page 4/7

5 the client can either cash settle the transaction or request to roll the transaction. Daily cash margining will occur based on changes in the price of the bond. Illustration of TRS without initial exchange Source: Natwest Markets [1yr] TRS NatWest Markets Sell UKT 2055 Fee [ + X bp] on GBP [180m] NatWest Markets UKT 2055 Coupons 4.25% on GBP [100m] Notional [1yr] Pre-Agreed Price (e.g. Spot) GBP [180m] LDI Client UKT /07/ GBP [100m] Notional (or cash equivalent) Ongoing Flows Final Flows 4) Cash vs. Derivatives Allocation for active managers As discussed above, the decision to choose cash or derivatives to hedge liabilities is evidently dependent on a range of different factors. In this section we concentrate on active LDI managers, assuming an indifference to hedging with cash and derivatives. For an active LDI manager, as the swap spread widens, i.e. the government bond underperforms the swap, LDI managers are likely to consider increasing their allocation to gilts and vice-versa when swap spreads tighten. If asset swap spreads are very volatile, the allocation should not change much per basis point change in the swap spread. That is to say there may be a perception that there will be a better opportunity to adjust the allocation towards gilts at some stage in the future. However, if swap spread volatility is very low, a basis point change may be quite significant and could therefore lead to a significant increase in the allocation to gilts. As an example, let s assume the 30-year swap spread has an expected value of 21bp and annual volatility of 16.5bp (based on long run average data since 2010) and that pension funds are indifferent between hedging with swaps or gilts at the expected swap spread level, due to the competing reasons given earlier. This allows us to calculate the probability of a certain level of swap spread and we can use this to direct our allocation to gilts and swaps. For example a swap spread of 30bp, equates to a probability of 71% and suggests an allocation weighted seven tenths to gilts and three tenths swaps. Allocating in this way is similar to option pricing with the delta obtained assuming a normal distribution and a one-year call option struck at 15bp. Page 5/7

6 30y swap spread distribution based on 16.5bp of annual vol Source: Natwest Markets Modelled allocation based on swap spreads Source: Natwest Markets % 80% 60% 40% 20% 0% Maturity Gilt Swap This idea can be used across the curve to give a rough idea of the allocation between swaps and gilts by maturity, as shown by the chart above. As swap spreads have narrowed over recent months, the allocation to swaps from gilts should theoretically have increased for active LDI managers. In the example shown above, the allocation between swaps/gilts is equal at ~20y point where the swap spread is approximately 21bp. Conclusions The combination of higher yields, cheaper gilt repo financing, additional costs associated with swaps and changes to benchmarks have pushed long-end swap spreads to their narrowest since May As financing solutions which don t affect bank s Leverage Ratio gain traction, we believe this is likely to continue. As swap spreads widened we saw an increase in investments in gilt repo and we may expect investments in swaps to increase while they narrow. Whilst in reality, the actually allocation to gilts vs. swaps may be higher than our theoretical approach above might suggest (50%:50% at 20y and 75%:25% at 30y) recent volatility is likely to temper demand for swaps if spreads continue to tighten further. That is to say we believe there is still scope for rising demand for gilts. New Trade: Buy UKT 3.5% 2045 vs. a matched maturity swap. Enter at 33bp, target 13bp and place a stop at 44bp. The risk to this trade is a more disruptive Brexit process is detrimental to the economy and pushes the Gilt financing remit higher. However, such in such a scenario markets would likely price in a higher probability of the resumption of Gilt QE, thereby providing some degree of counteraction against this. Page 6/7

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