JANUARY 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 The main highlights for December took place outside the UK. Firstly, the ECB disappointed by not increasing the pace of planned QE in line with what markets were expecting and this left yields higher generally including the UK. The time extension of QE from September 2016 to March 2017 along with a slightly wider basket of bonds was nowhere near the calls for extra monthly purchases of 10bn EUR plus. Secondly, the US November employment report early in the month surprised to the upside with labour markets continuing to improve, paving the way for the December rate hike which came to fruition after much of the year had been spent talking about it. Against this optimism, oil broke lower to around $35 from above $40 as OPEC announced they would not be cutting production. This negative sentiment kept a lid on yields and didn t help the performance of short-dated inflation. Previous talking points around gilt z-spreads were less dramatic month on month but there was still volatility with 30 year z-spread levels around 45bps at one point in the month. Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 31 December 2015 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.87% 2.70% 2.55% +16.1 +16.3 +15.5 Gilt Real Yields -0.57% -0.61% -0.75% +29.3 +15.8 +16.0 Gilt Breakeven Inflation 2.43% 3.31% 3.30% -13.3 +0.6-0.5 ZC Swap Rates 2.06% 2.20% 2.03% +19.3 +17.2 +16.5 RPI Swaps 3.06% 3.46% 3.47% -3.5 +3.1 +4.0 Gilt Z-Spreads (vs. 6mL) -7 53 48-2.7-1.0-1.4 Linker Z-Spreads (vs. 6mL) 41 59 60 +7.6 +2.2 +3.9 IOTA (Relative z-spread) 48 7 12 +10.3 +3.2 +5.3 Equities, Volatility & Credit Current Monthly Change FTSE 100 6,274-82 S&P 500 2,063-17 1y30y Swaption Vol 33.6% -3.5% FTSE 100 Implied Vol 19.9% +0.2% CDS - 10y itraxx (bps) 114 +10.5 CDS - 10y CDX (bps) 127 +9.9 6m LIBOR (bps) 75 +2.5 Key Events and Data Region Period Actual Consensus Prior Comments US non-farm payrolls US Nov 211,000 201,000 271,000 US GDP UK Q3 2015 0.4% 0.5% 0.5% UK Base rate decision UK Dec 0.5% 0.5% 0.5% UK CPI UK Nov 0.1% 0.1% -0.1% Annual inflation UK RPI UK Nov 1.1% 0.9% 0.7% Annual inflation UK unemployment UK 3m to Oct 5.2% 5.3% 5.3% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 1 Dec 2015 Syndication 0 1/8% Index-linked Treasury Gilt 2046 17 Dec 2015 Auction 1¼% Index-linked Treasury Gilt 2032 3.25-0.75% NA 0.70-0.72% 1.86 8 Dec 2015 Auction 3½% Treasury Gilt 2045 2.20 2.49% 1.38 2 Dec 2015 Auction 1½% Treasury Gilt 2021 3.75 1.26% 1.37
JANUARY 2016 LGIM LDI FUNDS 2 Market Data Interest rates 2.6 Inflation 4.0 2.4 3.8 3.6 2.2 2.0 3.4 3.2 1.8 3.0 1.6 2.8 1.4 10Y ZC IRS 30Y ZC IRS 2.6 10Y Inflation Swap 30Y Inflation Swap Interest rate curve 4 0.5 10Y ZC IRS 0.4 30Y ZC IRS Inflation curve 3.0 0.6 2.8 2.6 Dec-14 Mar-15 Jun-15 Sep-15 De 0.5 10Y Inflation Swap 30Y Inflation Swap 0.3 0.2 0.4 0.1 0.3-30Y - 10Y Zero Coupon Interest Rate Swap 0.2 30Y - 10Y Inflation Swap Z-spreads 70 60 50 Relative Z-spreads (IOTA) 50 40 Z-Spread (bps) 40 30 20 10 - (10) (20) (30) Gilt 2024 Gilt 2045 ILG 2024 ILG 2044 IOTA (bps) 30 20 10 - (10) IOTA 2024 IOTA 2045
JANUARY 2016 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding December 2014 November 2015 December 2015 SONIA 0.36% 0.45% 0.46% 3-Month LIBOR 0.56% 0.57% 0.59% 6-Month LIBOR 0.69% 0.73% 0.75% UK Gilt Total Return Swap: 6 Months 0.72% 0.87% 0.87% UK Gilt Total Return Swap: 1 Year 0.86% 1.00% 1.00% 6-Month Gilt Repo 0.67% 0.81% 0.81% 1-Year Gilt Repo 0.78% 0.93% 0.93% Note: TRS and repo pricing is transaction-based where possible, and can vary materially by counterparty Source: LGIM, Bloomberg L.P. Dec 15 TRS/REPO pricing left indentical to Nov 15 in absence of transactions. Swaptions market Interest rate swaption markets December 2014 November 2015 December 2015 3Y/20Y ATMF+1%: Premium 2.48% 2.70% 2.60% 3y/20y zero-cost collar +1%/ Y 0.94% 1.12% 1.14% ATMF (implied 20Y rate in 3Yrs) 2.45% 2.21% 2.38% Source: LGIM, Bloomberg L.P. HeatMap: zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.91% 1.05% 1.10% 1.14% 1.19% 2y 0.97% 1.10% 1.14% 1.17% 1.21% 3y 0.97% 1.08% 1.11% 1.14% 1.19% 4y 0.99% 1.11% 1.14% 1.15% 1.18% 5y 0.99% 1.12% 1.15% 1.16% 1.16% Source: LGIM, Bloomberg L.P.
JANUARY 2016 LGIM LDI FUNDS 4 Market Data UK (FTSE 100) December 2014 November 2015 December 2015 1Y 90% Put: cost 4.11% 4.27% 4.39% 1Y 90/70 put spread: cost 3.07% 3.17% 3.25% 1Y zero cost 90/70 Put Spread Collar: "X" 104.37% 104.86% 104.65% FTSE 100 Implied Volatility 17.95 16.95 16.92 FTSE 100 Forward/Spot 0.97 0.97 0.97 US (S&P 500) December 2014 November 2015 December 2015 1Y 90% Put: cost 3.92% 4.26% 4.19% 1Y 90/70 put spread: cost 2.84% 3.00% 2.98% 1Y zero cost 90/70 Put Spread Collar: "X" 106.59% 106.77% 106.65% S&P 500 Implied Volatility 17.95 16.95 16.92 S&P 500 Forward / Spot 0.99 0.99 0.99 Europe (Euro Stoxx 50) December 2014 November 2015 December 2015 1Y 90% Put: cost 5.40% 5.48% 5.70% 1Y 90/70 put spread: cost 3.96% 3.96% 4.10% 1Y zero cost 90/70 Put Spread Collar: "X" 106.17% 106.74% 106.33% Euro Stoxx 50 Implied Volatility 17.95 16.95 16.92 Euro Stoxx 50 Forward / Spot 0.97 0.97 0.97 Equity Replacement Strategies Equity Replacement Strategies December 2014 November 2015 December 2015 UK 1Y 100% Call 4.96% 5.31% 5.29% 1Y 105% Call 2.84% 3.11% 3.12% US 1Y 100% Call 5.97% 6.28% 6.21% 1Y 105% Call 3.47% 3.73% 3.66% EUR 1Y 100% Call 6.46% 6.72% 6.69% 1Y 105% Call 4.37% 4.58% 4.57% Source: LGIM, 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.
JANUARY 2016 LGIM LDI FUNDS 5 In Focus The short and long of it What does 2016 have in store? I m not sure anyone really knows the answer to that one so we ll start with an easier question of what happened in LDI markets in 2015. Observations: First, 2015 was very different to 2014. Looking at the 10-year gilt yield, 2014 was the year that 3 became 2 but happily 2015 has not been the year that 2 became 1. In fact outright yields have not been the story in 2015 and end at relatively similar levels albeit with a fair amount of volatility. Second, the short end (ie the rate set by central banks) was more exciting than the long end (ie 30-year yields) but unfortunately much less relevant for pension funds. Once again markets were hanging on every press conference, set of minutes and statement coming out of central bank land. Finally, it was the difference between yields on instruments (rather than the absolute level of yields) which took the headlines. Towards the end of the year especially, gilt yields and swap yields diverged. We expand on these areas in the rest of this piece as well as offering some thoughts for 2016. In summary, be prepared continues to be our motto (so hedging if the volatility of funding level is a problem) and if the level of yields is too low then it makes sense to be prepared for being prepared (so ensuring that the plumbing is in place to move quickly to take advantage of volatility if market conditions change) The short of it Monetary policy diverged with the UK stuck in the middle. The US finally hiked rates in December whilst Europe saw further cuts to the deposit rate. 1 0.8 0.6 0.4 0.2 0-0.2-0.4 24/12/2010 24/07/2011 24/02/2012 24/09/2012 24/04/2013 24/11/2013 24/06/2014 24/01/2015 24/08/2015 ECB deposit rate UK Bank Rate Fed Fund target rate (Upper bound) Source: Bloomberg L.P. Although the direct feed through into longer term yields is minimal, shorter term rates are certainly important because of their impact on sentiment and risky assets which then feed through into bond markets that way. The long of it After the material yield reductions in 2014, 2015 was a different affair with things ending not too far from where they began the year. That said there has certainly been volatility as the chart shows with a variety of issues emanating from overseas, namely the impact of the ECB quantitative easing programme and the dramatic falls in Chinese equities over Q3. However, longer maturity real gilt yields traded below -1% for the first time. 2.6 2.4 2.2 2.0 1.8 1.6 1.4 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 10Y ZC IRS 30Y ZC IRS Source: LGIM Analytics
JANUARY 2016 LGIM LDI FUNDS 6 What has been noteworthy is the changing shape of the yield curve over 2015 as longer term yields have fallen relative to shorter term yields. The chart below shows the demand for long duration assets and although intuitively this doesn t feel right, there are certainly forces at work which can prevent it from snapping back. On top of pension fund demand to hedge very longdated liabilities, investors are also keen to hold longer dated assets as it allows them to have less unfunded exposure. 0.5 0.4 0.3 0.2 0.1-30Y - 10Y Zero Coupon Interest Rate Swap The instrument of choice Towards the end of 2016, the spread between gilt yields and swap yields (z-spread) continued to diverge and 30-year nominal z-spreads hit 60bps in November before snapping back and finishing the year trading in the middle of a 40bps to 60bps range. This has generally been attributed to repo funding becoming gradually more expensive over the year and it s something that is by no means unique to the UK with a similar story playing out in the US. For more on this subject please see our note: LDI Monthly Wrap November 2015 Source: LGIM Analytics Z-Spread (bps) 70 60 50 40 30 20 10 - (10) (20) (30) Gilt 2024 Gilt 2045 ILG 2024 ILG 2044 Source: LGIM Analytics Inflation A relatively stable year for inflation with longer maturity swap rates trading fairly consistently in a 3.4% to 3.5% range. 4.0 3.8 3.6 3.4 3.2 3.0 2.8 2.6 10Y Inflation Swap 30Y Inflation Swap Source: LGIM Analytics
JANUARY 2016 LGIM LDI FUNDS 7 2016 and the path ahead Most importantly of all is the fact that a rise in short-term interest rates is priced into markets. This also follows through into longer term yields and means that rising yields do not automatically translate to falling liability values. The chart below shows the yield curve for today, a year from now and three years from now. An increase of 10 to 15 bps per year is already embedded into 20-year yields for the next three years. Put another way, if yields stay the same then liability values will increase. We covered this in more detail in a separate note: The Cost of Inaction August 2015 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 1 2 3 4 5 6 7 8 9 1011121314151617181920212223242526272829303132333435363738394041424344454647484950 ZC gilt curve (spot) ZC gilt curve (1 year from now) ZC gilt curve (3 years from now) Source: LGIM Analytics 22 December 2015 Given the large potential for global central bank, event and political risk in the current climate what we do know is that even if market conditions are relatively unchanged there are still opportunities to build up hedges. This was clear in 2015 with real yields trading earlier in the year at -0.6% and through -1% in a matter of months. Hence, addressing governance needs in advance of opportunities makes sense. This could be with the use of funding level triggers so something is pre-planned or it could be as easy as ensuring that the framework to implement changes already exists and any governance constraints have been taken care of in advance.
JANUARY 2016 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 160 150 140 130 120 110 100 90 80 70 60 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 160 150 140 130 120 110 100 90 80 70 60 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 Source: LGIM Source: LGIM
JANUARY 2016 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 Source: LGIM 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 70 90 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. 70 90 100 Upside participation up to level of X 100 X Zero-Cost Put Spread Collar Source: LGIM Source: LGIM Key risks The use of derivatives may expose schemes to additional risks. Please see the Key Risks information on page 8.
JANUARY 2016 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)20 7600 3568 +44 (0)20 3124 4247 +44 (0)20 3124 3569 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. 2015 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 www.lgim.com Authorised and regulated by the Financial Conduct Authority. M0692