MAY 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 April provided more good news on the outright yields front as bond and swap yields continued their rise higher (albeit the 2% 10-year swap levels at the start of the year are still some way off). The 2065 gilt syndication helped nominal yields on their upward trajectory as material supply came to the market. Against this long-dated inflation was not the most loved asset class and actually fell towards the 3.20% level which is at the lows of 2016 so far. As a long-term trend it is normal for inflation to behave with a beta around 0.5 versus yields ie a 10bp move in rates would expect to be accompanied by a 5bp move in inflation in the same direction. Conversely shorter dated inflation has bounced back in line with the recovery in oil prices. The relative difference between gilts and swaps reduced further and now stands around or below 60bps at longer maturities, some way from the 80bps levels reached earlier in the year. The difference between swap and gilt inflation for longer dated gilts contracted further and is at recent historic lows as can be seen seen by the red line in the IOTA chart below. Normally a premium for gilt inflation is exhibited because of the lower liquidity of index-linked gilts compared to gilts. In terms of supply the 2065 gilt syndication gave the DMO another headline worthy press release with an order book in excess of 21 billion GBP (the second highest ever). Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 29 April 2016 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.48% 2.40% 2.23% +19.2 +12.2 +10.4 Gilt Real Yields -0.99% -0.78% -0.91% +14.2 +12.0 +12.5 Gilt Breakeven Inflation 2.47% 3.18% 3.14% +5.0 +0.2-2.1 ZC Swap Rates 1.59% 1.80% 1.62% +13.1 +12.1 +12.3 RPI Swaps 2.94% 3.23% 3.20% -0.7-4.8-6.3 Gilt Z-Spreads (vs. 6mL) 4 63 57 +6.4-0.1-1.9 Linker Z-Spreads (vs. 6mL) 43 61 59-0.1-5.8-6.1 IOTA (Relative z-spread) 39-3 3-6.5-5.7-4.2 Key Events and Data Equities, Volatility & Credit Current Monthly Change FTSE 6,242 +67 S&P 500 2,065 +6 1y30y Swaption Vol 42.3% -4.4% FTSE Implied Vol 19.7% -1.5% CDS - 10y itraxx (bps) 108-0.2 CDS - 10y CDX (bps) 119 +5.9 6m LIBOR (bps) 74 +0.5 Region Period Actual Consensus Prior Comments US non-farm payrolls US Mar 215,000 202,000 242,000 US GDP UK Q1 2016 0.4% 0.4% 0.6% UK Base rate decision UK Apr 0.5% 0.5% 0.5% UK CPI UK Mar 0.5% 0.4% 0.3% Annual inflation UK RPI UK Mar 1.6% 1.4% 1.3% Annual inflation UK unemployment UK 3m to Feb 5.1% 5.1% 5.1% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 26 Apr 2016 Syndication 2½% Treasury Gilt 2065 4.75 2.29% NA 20 Apr 2016 Auction 0 1/8% Index-linked Treasury Gilt 2026 1.42-0.97% 2.00 13 Apr 2016 Auction 3½% Treasury Gilt 2045 2.01 2.35% 2.08 07 Apr 2016 Auction 1½% Treasury Gilt 2026 2.87 1.51% 1.96 05 Apr 2016 Auction 1½% Treasury Gilt 2021 3.16 0.80% 2.01
MAY 2016 LGIM LDI FUNDS 2 Market Data Interest rates Rate (%) s credit spreads on financi als moved higher subject to their exposure to the above factors 4.0 2.6 - The second half of the month did see risk assets stage a recovery as confidenc urn to markets. Again it was like ly factors outside the UK which prompted this revival namely soothing words from the ECB and the Fed whilst oil prospects were helpe /Saudi Arabia deal on supply. - 2.4 3.8 UK yields were lower in reaction to these events and didn't have the same end ce back seen in (for example) equi ties. Of particular note was the further divergence i gilt and swap spreads over the month as shown in the table attributable to a num ncluding bank positioning pos t syndication, insurance related demand for swaps and stop-outs of positions 2.2 3.6 - Other notable news in the UK was the referendum around membership of the E late June whilst a new 2065 index -linked gilt was issued to the market via syndication For all the talk about falling yields the talbe shows that there was a concession c event and 50y real yields ended very slightly higher on the month. 2.0 3.4 1.8 Rate (%) Inflation 3.2 1.6 3.0 1.4 2.8 1.2 10Y ZC IRS 30Y ZC IRS 2.6 10Y Inflation Swap 30Y Inflation Swap Interest rate curve 0.4 Inflation curve 0.6 0.6 Rate (%) 0.3 0.2 0.1 Rate (%) 0.5 0.5 0.4 0.4 0.3-30Y - 10Y Zero Coupon Interest Rate Swap 0.3 0.2 30Y - 10Y Inflation Swap Z-spreads Relative Z-spreads (IOTA) 50 80 40 Z-Spread (bps) 60 40 20 - IOTA (bps) 30 20 10 (20) - (40) Gilt 2024 Gilt 2045 Linker 2024 Linker 2044 (10) IOTA 2024 IOTA 2045
MAY 2016 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding SONIA 0.45% 0.41% 0.46% 3-Month LIBOR 0.57% 0.59% 0.59% 6-Month LIBOR 0.70% 0.74% 0.74% UK Gilt Total Return Swap: 6 Months 0.68% 0.82% 0.77% UK Gilt Total Return Swap: 1 Year 0.79% 0.85% 0.84% 6-Month Gilt Repo 0.69% 0.76% 0.76% 1-Year Gilt Repo 0.74% 0.83% 0.80% 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 3.07% 3.09% 3.04% 3y/20y zero-cost collar +1%/ Y 1.06% 1.08% 1.04% ATMF (implied 20Y rate in 3Yrs) 2.35% 1.83% 1.96%, Bloomberg L.P. HeatMap: zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.95% 1.03% 1.10% 1.14% 1.16% 2y 1.01% 1.14% 1.13% 1.14% 1.14% 3y 0.93% 0.99% 1.02% 1.04% 1.06% 4y 0.98% 1.03% 1.04% 1.04% 1.02% 5y 0.97% 1.04% 1.04% 1.03% 0.99%, Bloomberg L.P.
MAY 2016 LGIM LDI FUNDS 4 Market Data UK (FTSE ) 1Y 90% Put: cost 3.88% 4.95% 4.38% 1Y 90/70 put spread: cost 2.98% 3.55% 3.26% 1Y zero cost 90/70 Put Spread Collar: "X" 104.44% 104.57% 103.97% FTSE Implied Volatility 17.67 16.50 14.82 FTSE Forward/Spot 0.97 0.97 0.97 US (S&P 500) 1Y 90% Put: cost 3.98% 4.02% 4.13% 1Y 90/70 put spread: cost 2.89% 2.88% 2.95% 1Y zero cost 90/70 Put Spread Collar: "X" 106.18% 105.64% 106.02% S&P 500 Implied Volatility 14.55 13.95 15.22 S&P 500 Forward / Spot 0.99 0.98 0.99 Europe (Euro Stoxx 50) 1Y 90% Put: cost 5.16% 6.15% 5.94% 1Y 90/70 put spread: cost 3.89% 4.19% 4.11% 1Y zero cost 90/70 Put Spread Collar: "X" 105.76% 105.16% 104.86% Euro Stoxx 50 Implied Volatility 24.21 23.45 20.85 Euro Stoxx 50 Forward / Spot 0.97 0.96 0.96 Equity Replacement Strategies Equity Replacement Strategies UK 1Y % Call 4.88% 5.59% 5.03% 1Y 105% Call 2.78% 3.38% 2.86% US 1Y % Call 5.86% 5.70% 5.91% 1Y 105% Call 3.37% 3.15% 3.37% EUR 1Y % Call 6.23% 6.34% 6.11% 1Y 105% Call 4.15% 4.25% 4.06%, 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.
MAY 2016 LGIM LDI FUNDS 5 In Focus The regulatory (w)rap Asked about the causes of the financial crisis of 2008 it is fair to say that pension funds would be pleading not guilty. The ensuing changes in the regulatory environment have however certainly impacted pension funds to the point where many feel as though they are taking the rap. In focus this month is the regulatory (w)rap and some opinions around the important developments which have appeared on the horizon and now affect LDI portfolios. It s not all bad news and crucially it remains possible for pension funds to set up robust risk management frameworks that support the path to self-sufficiency or buy-out. Where is the impact being felt? We can probably sum up as saying that regulation impacts (or will impact): Who (ie which counterparties) you trade derivatives with and face over the lifetime of the contract How you trade those derivatives The ongoing management of those derivatives First of all, the who. Here we find ourselves delving into the European Market Infrastructure Regulation (EMIR). Strictly speaking this falls into the will impact box as pension schemes may generally rely on an exemption from central clearing until August 2017. A detailed timeline is available if anyone would care for the full detail but in summary at the point that the pension scheme exemption runs out (for interest rate swaps) the situation will be: Trade with anyone (in principle) Face the central counterparty over the lifetime of the trade Now onto the how. It is fair to say that this area has received less attention and will do for the immediate future. Nonetheless MIFID 2 will eventually arrive and have some impact on how derivatives are traded. Finally, the (slightly less catchy) ongoing management. As part of EMIR there are certain requirements around reporting and risk mitigation which are almost all picked up by an investment manager on behalf of the pension scheme. Perhaps more relevant is the collateral situation for pension funds. Coming in March 2017 we have the uncleared bilateral margin rules. Ultimately this looks as though it will result in compulsory margining of FX forwards. See our recent FX note for more information: For some time, other derivative contracts have been collateralised on an ongoing basis - out of choice - as pension funds are understandably not too keen on the unsecured credit risk of a counterparty bank. Related to collateral but not enshrined in this set of rules is the types of eligible collateral written into swap agreements. Of course we are referring to the cash versus cash and gilts decision which was thrust into the limelight probably 12 months ago. Is this area the odd one out given that no regulation presently directly impacts pension funds? Clearing is a cash margining system (with the pension fund exemption supposedly in place to provide a solution which enables non-cash margin) but the effects of using non-cash collateral have been felt far before anything compulsory in terms of: Valuation transparency Potential execution pricing Our recent update picks up this area in more detail: In this case it is the regulation of the banking sector which is indirectly impacting pension funds. Basel 3 is different to previous guises because government bonds have a genuine impact on certain balance sheet factors for the bank. Ultimately this finds its way back to the end investor, for example a pension fund. We ve got this far without even mentioning how cash collateral is raised, namely gilt repo. Suffice it to say that we have discussed this in previous editions and this is simply more of the same where gilt repo can have a much more significant impact on bank balance sheets than it ever has historically. Also, from July 2017, The Security Financing Transactions Regulations will require counterparties to report repos to trade repositories. So although some regulation has a direct impact on pension funds (such as EMIR) this does not mean that other regulation can be ignored. As highlighted above the likes of Basel 3 certainly have ramifications for pension funds, albeit these are felt second hand via dealings with counterparty banks. What does it all mean? Does the interaction of regulation with investments makes the world a more complex place? 1. If desired, complexity is best avoided by using the most transparent liquid derivatives and delegating more to the investment manager/ consultant. That s not to say there is no part for complexity. All we would say is that where approach is non-standard compared to the market then there should be a strong rationale for the benefits to offset the extra time and resource required. 1 If you are in a (single or multi-investor) pooled fund then many of the above topics are automatically delegated to LGIM.
MAY 2016 LGIM LDI FUNDS 6 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 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 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
MAY 2016 LGIM LDI FUNDS 7 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 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 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 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.
MAY 2016 LGIM LDI FUNDS 8 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. 2016 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. M0956