LDI MONTHLY WRAP Monthly Market Update MARKET CONDITIONS AS AT COB 30 JUNE 2018 Rates Maturity Monthly change (bps) 10y 30y 50y 10y 30y 50y Gilt Yields 1.28% 1.73% 1.57% +5.7 +4.6 +7.8 Gilt Real Yields -1.77% -1.56% -1.59% +5.9 +4.8 +4.6 Gilt Breakeven Inflation 3.05% 3.29% 3.16% -0.1-0.2 +3.2 OIS ZC Swap Rates 1.21% 1.30% 1.18% +7.9 +8.9 +12.0 RPI Swaps 3.34% 3.40% 3.23% +3.7 +1.6 +2.5 Gilt Z-Spreads (vs. OIS) 11 45 36-1.9-4.1-3.0 Linker Z-Spreads (vs. OIS) 30 49 41-2.8-4.1-5.7 IOTA (Relative z-spread) 19 4 5-0.9 + -2.7 Equities, Volatility & Credit Current Monthly Change FTSE 100 7,637-41 S&P 500 2,718 +13 1y30y Swaption Vol 59-3 FTSE 100 Implied Vol 16.0% +0.1% CDS - 10y itraxx (bps) 117 +3.8 CDS - 10y CDX (bps) 112 +1.2 SONIA (bps) 44-1.0 KEY EVENTS AND DATA Region Period Actual Consensus Prior Comments US non-farm payrolls US May 223,000 191,000 164,000 UK GDP UK Q1 2018 0.2% 0.1% 0.1% UK Base rate decision UK Jun 0.50% 0.50% 0.50% UK CPI UK May 2.4% 2.5% 2.4% Annual inflation UK RPI UK May 3.3% 3.4% 3.4% Annual inflation UK unemployment UK 3m to Apr 4.2% 4.2% 4.2% SUPPLY Date Type Bond Nominal ( bn) Yield Bid/Cover 10/04/2018 Auction 2057 conventional gilt 2.00 1.66% 1.98 19/04/2018 Auction 2028 conventional gilt 2.50 1.60% 2.39 24/04/2018 Auction 2048 index-linked gilt 0.75-1.41% 2.16 03/05/2018 Auction 2023 conventional gilt 3.00 1.12% 1.88 09/05/2018 Auction 2028 conventional gilt 2.75 1.61% 2.20 15/05/2018 Syndication 2071 conventional gilt (new) 6.00 1.69% 37.8bn 24/05/2018 Auction 2036 index-linked gilt 1.00-1.49% 2.15 06/06/2018 Auction 2023 conventional gilt 2.75 1.04% 1.95 20/06/2018 Auction A new index-linked gilt maturing on 10 August 2028 1.25-1.71% 2.23 26/06/2018 Auction 2037 conventional gilt 2.25 1.78% 2.02 03/07/2018 Auction 2028 conventional gilt 2.50 1.43% 2.30 11/07/2018 Syndication A new index-linked gilt maturing on 10 August 2041 19/07/2018 Auction 2057 conventional gilt 24/07/2018 Auction A new conventional gilt maturing on 22 April 2024 08/08/2018 Auction 2028 conventional gilt 21/08/2018 Auction A new index-linked gilt maturing on 10 August 2028 06/09/2018 Auction A new conventional gilt maturing on 22 April 2024 11/09/2018 Auction A new conventional gilt maturing on 22 January 2049 20/09/2018 Auction 2028 conventional gilt 25/09/2018 Auction 2048 index-linked gilt
Market Data Interest rates Inflation 2.5 3.6 2.0 3.5 3.4 Yield (%) 1.5 1.0 Rate (%) 3.3 3.2 3.1 0.5 3.0 Gilt 2027 Gilt 2049 Gilt 2068 2.9 10Y Inflation Swap 30Y Inflation Swap 50Y Inflation Swap Interest rate curve Inflation curve 0.8 0.2 0.6 0.2 0.1 0.4 0.1 Rate (%) 0.2 Rate (%) -0.1-0.1-0.2-0.2-0.4-0.2 30Y - 10Y ZC Gilt Rate 50Y - 30Y ZC Gilt Rate 30Y - 10Y Inflation Swap 50Y - 30Y Inflation Swap Z-spreads Relative Z-spreads (IOTA) 6 35.0 5 3 25.0 4 2 Z-Spread (vs OIS bps) 3 2 1 IOTA (bsp) 15.0 1 5.0-5.0-1 Gilt 2027 Gilt 2049 Gilt 2068 IOTA 2027 IOTA 2049 IOTA 2068 2
LDI Monthly Wrap July 2018 Swaptions, Equities, Short-term interest rates and funding SHORT-TERM INTEREST RATES AND FUNDING Benchmark Rates June 2017 May 2018 June 2018 SONIA (%) 0.19% 0.45% 0.44% 3 Month SONIA swap (%) 0.26% 0.48% 0.56% 6 Month SONIA swap (%) 0.30% 0.53% 0.61% 12 Month SONIA swap (%) 0.38% 0.59% 0.68% Bond Funding (bps spread over equivalent maturity SONIA swap) 3 Month Gilt Repo +17 bps +12 bps +12 bps 6 Month Gilt Repo +17 bps +13 bps +15 bps 12 Month Gilt Repo +12 bps +16 bps +16 bps Equity Funding (bps spread over equivalent maturity SONIA swap) 1 Year FTSE 100 TRS in GBP +33 bps +25 bps +33 bps 1 Year S&P 500 TRS in GBP +30 bps +29 bps +35 bps 1 Year MSCI World TRS in GBP +42 bps +39 bps +44 bps Note: TRS and repo pricing is transaction-based where possible, and can vary materially by counterparty., Bloomberg L.P., LGIM Counterparties Annualised funding cost 6M LIBOR-SONIA 0.7% 0.6% 0.5% 0.4% 0.3% 0.2% 0.1% % -0.1% May-12 May-13 May-14 May-15 May-16 May-17 May-18 Gilt Repo (3 Month) Relative to SONIA FTSE 100 TRS (1-Year) Relative to SONIA S&P 500 (in GBP) TRS (1-Year) Relative to SONIA 0.45% 0.40% 0.35% 0.30% 0.25% 0.20% 0.15% 0.10% 5% 0% Jun-17 Sep-17 Dec-17 Mar-18 10y 30y 50y, Bloomberg L.P., LGIM Counterparties INTEREST RATE SWAPTION MARKETS June 2017 May 2018 June 2018 3Y/20Y ATMF+1%: Premium 2.69% 2.23% 2.00% 3y/20y zero-cost collar +1%/-"Y" 0.94% 0.84% 0.86% ATMF (implied 20Y rate in 3Yrs) 1.78% 1.68% 1.73%, Bloomberg L.P. ZERO-COST COLLAR +1%/-Y Underlying swap tenor 5y 10y 15y 20y 30y 1y 0.76% 0.84% 0.86% 0.88% 0.90% 2y 0.77% 0.82% 0.85% 0.88% 0.92% Option tenor 3y 0.77% 0.81% 0.84% 0.86% 0.90% 4y 0.76% 0.81% 0.83% 0.85% 0.89% 5y 0.76% 0.81% 0.83% 0.85% 0.88%, Bloomberg L.P. 3
Swaptions, Equities, Short-term interest rates and funding. UK (FTSE 100) June 2017 May 2018 June 2018 1Y 90% Put: cost 3.39% 3.10% 3.12% 1Y 90/70 put spread: cost 2.78% 2.51% 2.54% 1Y zero cost 90/70 Put Spread Collar: "X" 102.56% 102.74% 102.89% FTSE 100 Implied Volatility 13.03 13.53 13.71 FTSE 100 Forward / Spot 0.96 0.97 0.97 US (S&P 500) June 2017 May 2018 June 2018 1Y 90% Put: cost 2.81% 2.97% 3.14% 1Y 90/70 put spread: cost 2.13% 2.11% 2.21% 1Y zero cost 90/70 Put Spread Collar: "X" 106.60% 108.41% 108.35% S&P 500 Implied Volatility 11.18 15.43 16.09 S&P 500 Forward / Spot 1.00 1.01 1.01 EUROPE (EURO STOXX 50) June 2017 May 2018 June 2018 1Y 90% Put: cost 4.27% 3.68% 3.86% 1Y 90/70 put spread: cost 3.32% 2.90% 3.00% 1Y zero cost 90/70 Put Spread Collar: "X" 104.47% 103.12% 102.65% Euro Stoxx 50 Implied Volatility 17.25 17.65 16.63 Euro Stoxx 50 Forward / Spot 0.97 0.97 0.96 EQUITY REPLACEMENT STRATEGIES Equity Replacement Strategy June 2017 May 2018 June 2018 UK 1Y 100% Call 3.83% 3.65% 3.74% 1Y 105% Call 1.96% 1.74% 1.83% US 1Y 100% Call 5.30% 6.32% 6.45% 1Y 105% Call 2.74% 3.53% 3.64% EUR 1Y 100% Call 5.21% 4.21% 4.11% 1Y 105% Call 3.12% 2.24% 2.17% 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. Implied volatilites are based off short maturity options (approximately 30 days) namely VFTSE, VIX and V2X for UK, US and Europe respectively. 4
LDI Monthly Wrap July 2018 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 7. 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 7. 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 ATMF Hedge provided if rate goes above ATMF+1% 0% 1% 2% 3% 4% Unhedged Position 20-year swap rate in 3 years 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% Unhedged Position 20-year swap rate in 3 years Position with Zero-Cost Collar 5
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 oneyear 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) 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) 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 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 100 equity holding. Protection against market falls of between 10% and 30% 70 90 100 150% 140% 130% 120% 110% 100% 90% 80% 70% 60% 60% 80% 100% 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 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 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 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 KEY RISKS Protection against market falls of between 10% and 30% 70 90 Upside participation up to level of X Zero-Cost Put Spread Collar The use of derivatives may expose schemes to additional risks. Please see the Key Risks information on page 7. 100 X 6
LDI Monthly Wrap July 2018 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. 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. 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. Repo pricing is shown as an annualised fixed funding cost for 3-month, 6-month and 1-year contracts. 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. 7
CONTACT US For more information please contact: Robert Pace Anne-Marie Morris (née Cunnold) Femi Bart-Williams Senior Solutions Strategy Manager Senior Solutions Strategy Manager Senior Solutions Strategy Manager robert.pace@lgim.com anne-marie.morris@lgim.com femi.bart-williams@lgim.com +44 (0)20 3124 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. As required under applicable laws Legal & General will record all telephone and electronic communications and conversations with you that result or may result in the undertaking of transactions in financial instruments on your behalf. Such records will be kept for a period of five years (or up to seven years upon request from the Financial Conduct Authority (or such successor from time to time)) and will be provided to you upon request. 2018 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. 8