APRIL 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 A relatively benign month all in all. The bounce back in sentiment continued its momentum after the lows in mid February with risk assets in particular being the beneficiaries as equities rose and credit spreads fell. Yields offered little excitement as the heatmap demonstrates. Stand-out changes came at shorter maturities in inflation as oil price stability helped rates move higher along with the more positive outlook. There were once again big moves between gilts and swaps. This time it was gilts staging a mini comeback as z-spreads fell back following last months bloodbath. On the central bank trail the ECB managed to leave investors in good cheer as they reduced the deposit rate by 10bps to -0.4%, increased the size of the quantitative easing programme and widened the eligible bonds available to purchase to include credit There was similar good news out of the US as the Federal Reserve moved closer to market pricing with its belief that there would now only be two rate hikes over the year. Back in the UK the DMO announced that the upcoming fiscal year would see more auctions which in turn would be smaller. There were also a series of other changes which can be seen on the DMO website designed to improve the auction process and ultimately reduce the cost of borrowing for the UK government. Femi Bart-Williams Senior Product Specialist Market Conditions as at COB 31 March 2016 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.29% 2.28% 2.12% +8.6-1.1-2.4 Gilt Real Yields -1.13% -0.90% -1.04% -12.4-7.6-7.4 Gilt Breakeven Inflation 2.42% 3.18% 3.16% +21.0 +6.5 +5.1 ZC Swap Rates 1.45% 1.67% 1.50% +16.4 +14.4 +12.7 RPI Swaps 2.95% 3.28% 3.26% +21.7 +4.0 +1.1 Gilt Z-Spreads (vs. 6mL) -3 63 59-6.4-16.0-15.9 Linker Z-Spreads (vs. 6mL) 43 66 65-2.5-17.9-18.8 IOTA (Relative z-spread) 46 3 7 +3.9-1.9-3.0 Equities, Volatility & Credit Current Monthly Change FTSE 6,175 +78 S&P 500 2,060 +128 1y30y Swaption Vol 46.7% -6.9% FTSE Implied Vol 21.3% -2.6% CDS - 10y itraxx (bps) 108-35.1 CDS - 10y CDX (bps) 114-3.4 6m LIBOR (bps) 74 +0.3 Key Events and Data Region Period Actual Consensus Prior Comments US non-farm payrolls US Feb 242,000 193,000 151,000 US GDP UK Q4 2015 0.6% 0.5% 0.5% UK Base rate decision UK Mar 0.5% 0.5% 0.5% UK CPI UK Feb 0.3% 0.3% 0.3% Annual inflation UK RPI UK Feb 1.3% 1.3% 1.3% Annual inflation UK unemployment UK 3m to 5.1% 5.1% 5.1% Supply Date Type Bond Nominal ( bn) Yield Bid/ cover 23 Mar 2016 Mini tender 0 1/8% Index-linked Treasury Gilt 2068 10 Mar 2016 Auction 0 1/8% Index-linked Treasury Gilt 2036 0.35-1.08% 1.44 1.05-0.92% 2.28 8 Mar 2016 Auction 3¾% Treasury Gilt 2052 1.37 2.22% 1.73 2 Mar 2016 Auction 1½% Treasury Gilt 2021 3.85 0.86% 1.54
APRIL 2016 LGIM LDI FUNDS 2 Market Data Interest rates Inflation ed the deposit rate by 10bps to -0.4%, increased the size of the quantitative easing - On the central bank trail the ECB managed to leave investors in good cheer as they 4.0 programme 2.6 and widened the eligble bonds available to purchase to include credit et pricing with its belief that there would now only be 2 rate hikes over the year. - There was similar good news out of the US as the Federal Reserve moved closer to - Back in the UK the DMO announced that the upcoming fiscal year would see more ns which 3.8 in turn would be smaller. There were also a series of other changes which ca seen 2.4 on the DMO website designed to improved the auction process and ultimately r the cost of borrowing for the UK government. 3.6 2.2 Rate (%) 2.0 Rate (%) 3.4 3.2 1.8 1.6 1.4 Mar-15-15 Jul-15-15 Nov-15-16 Mar-16 Int 10Y Int 30Y 3.0 2.8 2.6 Mar-15 Jun-15-15 Dec-15 Mar-16 10Y Inflation Swap 30Y Inflation Swap Interest rate curve 1.6 0.4 1.4 Mar-15-15 Jul-15-15 Nov-15-16 Mar-16 0.3 Int 10Y Int 30Y Inflation curve 8 0.6 6 0.6 Mar-15 Jun-15-15 Dec-15 Mar-16 0.510Y Inflation Swap 30Y Inflation Swap Rate (%) 0.2 Rate (%) 0.5 0.4 0.4 0.1 0.3 0.3 - Mar-15 Jun-15-15 Dec-15 Mar-16 30Y - 10Y Zero Coupon Interest Rate Swap 0.2 Mar-15 Jun-15-15 Dec-15 Mar-16 30Y - 10Y Inflation Swap Z-spreads 30Y - 10Y Zero Coupon Interest Rate Swap Relative Z-spreads (IOTA) 50 80 40 Z-Spread (bps) 60 40 20 IOTA (bps) 30 20-10 (20) - (40) Mar-15 Jun-15-15 Dec-15 Mar-16 Gilt 2024 Gilt 2045 Linker 2024 Linker 2044 (10) Mar-15 Jun-15-15 Dec-15 Mar-16 IOTA 2024 IOTA 2045
APRIL 2016 LGIM LDI FUNDS 3 Market Data Short-term interest rates and funding SONIA 0.42% 0.45% 0.41% 3-Month LIBOR 0.57% 0.59% 0.59% 6-Month LIBOR 0.68% 0.74% 0.74% UK Gilt Total Return Swap: 6 Months 0.67% 0.75% 0.82% UK Gilt Total Return Swap: 1 Year 0.85% 0.83% 0.85% 6-Month Gilt Repo 0.66% 0.75% 0.76% 1-Year Gilt Repo 0.75% 0.78% 0.83% 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 3.56% 3.36% 3.09% 3y/20y zero-cost collar +1%/ Y 0.98% 0.94% 1.08% ATMF (implied 20Y rate in 3Yrs) 2.12% 1.67% 1.83%, Bloomberg L.P. HeatMap: zero-cost collar +1%/-Y Option tenor Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.93% 1.28% 1.16% 1.20% 1.26% 2y 1.00% 1.30% 1.19% 1.20% 1.24% 3y 0.92% 0.99% 1.04% 1.08% 1.17% 4y 0.98% 1.07% 1.08% 1.10% 1.16% 5y 0.97% 1.07% 1.08% 1.09% 1.11%, Bloomberg L.P.
APRIL 2016 LGIM LDI FUNDS 4 Market Data UK (FTSE ) 1Y 90% Put: cost 3.87% 5.95% 4.95% 1Y 90/70 put spread: cost 2.98% 4.06% 3.55% 1Y zero cost 90/70 Put Spread Collar: "X" 104.06% 105.49% 104.57% FTSE Implied Volatility 16.33 22.06 16.50 FTSE Forward/Spot 0.97 0.97 0.97 US (S&P 500) 1Y 90% Put: cost 4.00% 5.10% 4.02% 1Y 90/70 put spread: cost 2.89% 3.48% 2.88% 1Y zero cost 90/70 Put Spread Collar: "X" 106.19% 107.18% 105.65% S&P 500 Implied Volatility 15.29 20.55 13.95 S&P 500 Forward / Spot 0.99 0.98 0.98 Europe (Euro Stoxx 50) 1Y 90% Put: cost 4.97% 7.29% 6.15% 1Y 90/70 put spread: cost 3.73% 4.79% 4.19% 1Y zero cost 90/70 Put Spread Collar: "X" 106.32% 105.64% 105.16% Euro Stoxx 50 Implied Volatility 21.10 29.73 23.45 Euro Stoxx 50 Forward / Spot 0.97 0.95 0.96 Equity Replacement Strategies Equity Replacement Strategies UK 1Y % Call 4.71% 6.48% 5.59% 1Y 105% Call 2.64% 4.24% 3.38% US 1Y % Call 5.89% 6.96% 5.70% 1Y 105% Call 3.38% 4.40% 3.15% EUR 1Y % Call 6.29% 7.10% 6.34% 1Y 105% Call 4.18% 5.02% 4.25%, 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.
APRIL 2016 LGIM LDI FUNDS 5 In Focus The Funding Conundrum is the grass greener on the other side? Last month we talked about repo funding but noted that the future of funding remains wider than just gilt repo - an ability to use different sources of leverage such as equities, credit, futures, etc. In Focus this month is that wider discussion around funding sources and we ask whether the grass is greener on the other side - are alternatives to gilt repo truly compelling options? Overall, we find that at the very least there are good reasons to have the flexibility to introduce alternative funding if it is ever really needed. Quite simply derivative overlays are the new LDI overlays with: Built-in potential flexibility over the source of funding (either at outset or on an ongoing basis) Efficient implementation, as collateral pools are shared amongst different asset classes (for bespoke mandates) Low governance implementation leveraging off existing documentation where possible Whilst alternatives to gilt funding are becoming useful tools it is worth remembering that gilt leverage remains the purest form of leverage, by which we mean that frictional costs (arising due to transition or basis risks between synthetic/physical asset) are minimised. Hence, a simple headline funding cost comparison does not give the whole picture and we believe it makes most sense to have a more strategic rationale in mind when moving away from gilt repo. Once the tools are in place we find that there are often then secondary benefits, such as the ability to rebalance and change asset allocation in short order. What s the alternative to gilt repo? We mentioned both credit and equity derivatives above as some of the main candidates providing an alternative to gilt repo. Equity derivatives We begin by setting the scene with some charts showing funding conditions in the UK and US. First, we can see that one-year equity funding has not increased in price in the same way as gilt repo funding over the last year. This immediately prompts the question as to whether this is an alternative to gilt repo. We come back to this. Figure 1. Funding Cost for 1-Year Synthetic Exposure (Spread to 3-Month GBP Libor 0.40% 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 0.05% 0.00% Mar 2015 Apr 2015 2015 Jun 2015 Jul 2015 Aug 2015 2015 Oct 2015 Nov 2015 Dec 2015 2016 Feb 2016 0.22% 0.18% Gilt Repo FTSE TRS Source: BAML, JPM Second, we observe that the implied funding costs from US equities are often less than UK equities with that being particularly apparent at the moment. Differences usually arise when trading is strongly directional and counterparties are willing to offer attractive terms to offset a material net short from their books. At the moment one of the drivers is thought to be US pension funds replacing synthetic positions with physical US equity. Finally, it is interesting to note that the recent reduction in the cost of equity funding goes some way to reverse the increased costs which started in 2012. At that point a combination of factors including strong investor demand to hold long equity position whilst the commitment of banks to their market making business meant that equity funding was much higher than gilt funding. With equity funding getting cheaper whilst gilt funding increases due to regulatory constraints, the headline funding costs are now relatively similar.
APRIL 2016 LGIM LDI FUNDS 6 Figure 2. 1-Year TRS: SP500 and FTSE (Spread to 3-Month USD & GBP Libor respectively) 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% -0.10% -0.20% -0.30% -0.40% -0.50% 2007 Oct 2007 Jul 2008 Apr 2009 2010 Oct 2010 Jul 2011 Apr 2012 2013 Oct 2013 Jul 2014 Apr 2015 2016 SP 500 TRS FTSE TRS Source: BAML (assumes US equity not FX hedged) So, going back to our earlier question, does this mean that now is the time to be synthesising equities instead of gilts? We would argue that the detail is important here and it is important to look at more than just the headline difference in funding costs. When you consider some of the issues around moving between physical and synthetic equities then there is not necessarily a strong case to be doing this very dynamically without considering the knock-on impact it would have. That said there certainly is a strong argument for leaving open the possibility of accessing this source of funding and (given sufficient governance or delegation) then it would be reasonable to consider using the synthetic equity market for some funding on a more buy and hold basis. Some of the key things to address are as follows: Longevity of the funding benefit: equity TRS funding tends to be more volatile than gilts so there is no guarantee that the same attractive terms could be achieved at each roll Implementation considerations: Many of the dislocations with equity funding are around a specific region so the existing physical equity portfolio may or may not be condusive to isolating physical equity for one area but synthetic in another Transition between physical and derivative exposure must be done in an efficient manner and consider any tax or other implications Ongoing portfolio implications: Rebalancing an equity portfolio (if TRS are used) becomes harder unless there are pre-agreed break terms up front. Futures provide more flexibility but generally more basis risk compared to a physical portfolio Any FX overlay would need to be considered Credit derivatives We last wrote about credit default swaps (CDS) back in 2015. In this piece we leave CDS to one side as a direct replacement for gilt repo because some of the properties which can make CDS attractive (liquidity, global nature, different constituents) result in quite a lot of basis risk versus a physical credit portfolio. Furthermore if you genuinely needed some liquidity, it is unlikely to be the time that you flip physical credit into CDS: this is likely to coincide with stressed market conditions where physical transaction costs are high and the difference between physical yields and CDS spreads are high (which acts against you on the trade). Figure 3. CDS versus physical credit spreads 400 350 300 Spread (bps) 250 200 150 50 0 2009 2010 2010 2010 itraxx Main CDS 2011 2011 2011 2012 2012 iboxx EUR corporates 2012 Source: Thomson Reuters That s not to say that you wouldn t use CDS, more that you would try to avoid switching from physical credit to CDS at stressed times if at all possible. It is in theory possible to use TRS on physical credit indices but it is generally going to be preferable to gain exposure via the on the run CDS contract which rolls every six months. 2013 2013 2013 2014 2014 2014 2015 2015 2015 2016
APRIL 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 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
APRIL 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 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.
APRIL 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)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. M0851