monthly market updatedecember 2018 ldi monthly rap ldi monthly wrap monthly market update rates...

December 2018 LDI Monthly Wrap

LDI M O N T H LY W R A PMonthly Market Update

Rates Maturity Monthly change (bps)

10y 30y 50y 10y 30y 50y

Gilt Yields 1.35% 2.06% 1.97% -8.8 +20.3 +19.4

Gilt Real Yields -2.03% -1.38% -1.39% -18.5 +18.5 +21.0

Gilt Breakeven Inflation 3.37% 3.45% 3.36% +9.6 +1.8 -1.6

OIS ZC Swap Rates 1.29% 1.55% 1.51% -3.2 +11.5 +13.5

RPI Swaps 3.58% 3.54% 3.44% +6.5 -2.5 -2.3

Gilt Z-Spreads (vs. OIS) 8 55 49 -5.4 +11.1 +8.6

Linker Z-Spreads (vs. OIS) 21 58 49 -10.5 +4.7 +5.5

IOTA (Relative z-spread) 13 3 0 -5.1 -6.3 -3.1

Equities, Volatility & Credit

Current Monthly Change

FTSE 100 6,980 -148

S&P 500 2,760 +48

1y30y Swaption Vol 64 +2

FTSE 100 Implied Vol 17.2% +0.5%

CDS - 10y iTraxx (bps) 124 +6.9

CDS - 10y CDX (bps) 122 +7.2

SONIA (bps) 70 +0.0

MARKET CONDITIONS AS AT COB 30 NOVEMBER 2018

Region Period Actual Consensus Prior Comments

US non-farm payrolls US Oct 250,000 198,000 134,000

UK GDP UK Q3 2018 0.6% 0.6% 0.0%

UK Base rate decision UK Nov 0.75% 0.75% N/A

UK CPI UK Oct 2.4% 2.5% 2.4% Annual inflation

UK RPI UK Oct 3.3% 3.4% 3.3% Annual inflation

UK unemployment UK 3m to Sep 4.1% 4.0% 4.0%

KEY EVENTS AND DATA

Date Type Bond Nominal (£bn) Yield Bid/Cover

26/06/2018 Auction 2037 conventional gilt 2.25 1.78% 2.02


11/07/2018 Syndication 2041 index-linked gilt 3.25 -1.62% £20.6bn




21/08/2018 Auction 2028 index-linked gilt 1.10 -1.79% 2.29






w/c 08/10/2018 Syndication 2071 conventional gilt 5.25 1.92% £28.3bn








08/01/2019 Auction 2028 conventional gilt TBA TBA TBA



Late Jan - mid Feb 2019 Syndication 2041 index-linked gilt TBA TBA TBA



26/02/2019 Auction 2028 index-linked gilt TBA TBA TBA



26/03/2019 Auction 2048 index-linked gilt TBA TBA TBA

SUPPLY

2


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Market Data

Interest rates Inflation

Interest rate curve Inflation curve

Z-spreads Relative Z-spreads (IOTA)

3

LDI Monthly Wrap December 2018

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

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

MSCI World (in GBP) TRS (1-Year) relative to SONIA

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

0.30%

0.35%

0.40%

0.45%


10y30y50y

-0.1%

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

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

MSCI World (in GBP) TRS (1-Year) relative to SONIA

0.00%

0.05%

0.10%

0.15%

0.20%

0.25%

0.30%

0.35%

0.40%

0.45%


10y30y50y

Benchmark Rates November 2017 October 2018 November 2018

SONIA (%) 0.46% 0.70% 0.70%

3 Month SONIA swap (%) 0.48% 0.71% 0.71%

6 Month SONIA swap (%) 0.50% 0.74% 0.73%

12 Month SONIA swap (%) 0.60% 0.81% 0.80%

Bond Funding (bps spread over equivalent maturity SONIA swap)

3 Month Gilt Repo +12 bps +21 bps +24 bps



Equity Funding (bps spread over equivalent maturity SONIA swap)

1 Year FTSE 100 TRS in GBP +30 bps +27 bps +34 bps

1 Year S&P 500 TRS in GBP +33 bps +44 bps +40 bps

1 Year MSCI World TRS in GBP +41 bps +48 bps +42 bps

Note: TRS and repo pricing is transaction-based where possible, and can vary materially by counterparty.

SHORT-TERM INTEREST RATES AND FUNDING

November 2017 October 2018 November 2018

3Y/20Y ATMF+1%: Premium 2.38% 2.11% 2.21%

3y/20y zero-cost collar +1%/-"Y" 0.87% 0.89% 0.91%

ATMF (implied 20Y rate in 3Yrs) 1.71% 1.81% 1.87%

INTEREST RATE SWAPTION MARKETS

Source: LGIM, Bloomberg L.P., LGIM Counterparties

Source: LGIM, Bloomberg L.P., LGIM Counterparties

Swaptions, Equities, Short-term interest rates and funding

Annualised funding cost 6M LIBOR-SONIA

Source: LGIM, Bloomberg L.P.

Underlying swap tenor

5y 10y 15y 20y 30y

Option tenor

1y 0.89% 0.91% 0.91% 0.94% 0.95%

2y 0.85% 0.89% 0.89% 0.93% 0.96%

3y 0.83% 0.88% 0.88% 0.91% 0.94%

4y 0.82% 0.87% 0.87% 0.90% 0.92%

5y 0.81% 0.86% 0.86% 0.89% 0.91%

Source: LGIM, Bloomberg L.P.

ZERO-COST COLLAR +1%/-Y

4



1Y 90% Put: cost 2.98% 3.46% 3.59%

1Y 90/70 put spread: cost 2.48% 2.82% 2.87%

1Y zero cost 90/70 Put Spread Collar: "X" 102.84% 102.70% 103.13%

FTSE 100 Implied Volatility 10.84 16.84 17.86

FTSE 100 Forward / Spot 0.97 0.96 0.97

Swaptions, Equities, Short-term interest rates and funding.

UK (FTSE 100)


1Y 90% Put: cost 2.67% 3.55% 3.49%

1Y 90/70 put spread: cost 1.95% 2.58% 2.60%


S&P 500 Implied Volatility 11.28 21.23 18.07

S&P 500 Forward / Spot 1.00 1.01 1.01

US (S&P 500)


1Y 90% Put: cost 3.83% 3.97% 3.87%

1Y 90/70 put spread: cost 3.02% 3.00% 2.97%


Euro Stoxx 50 Implied Volatility 13.47 20.30 18.49

Euro Stoxx 50 Forward / Spot 0.97 0.96 0.96

EUROPE (EURO STOXX 50)

Equity Replacement Strategy November 2017 October 2018 November 2018

UK 1Y 100% Call 3.64% 3.92% 4.17%

1Y 105% Call 1.76% 2.03% 2.23%

US 1Y 100% Call 5.48% 7.38% 7.15%

1Y 105% Call 2.78% 4.65% 4.46%

EUR 1Y 100% Call 4.53% 4.30% 4.12%

1Y 105% Call 2.49% 2.39% 2.27%

EQUITY REPLACEMENT STRATEGIES

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.

5


Swaptions educational refresher

SWAPTIONS EDUCATIONAL REFRESHERATMF 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.

Swaption: impact (for illustrative purposes only) Swaption collar: impact (for illustrative purposes only)

Unhedged exposure to rates

Hedge provided if rate goes above ATMF+1%

ATMF

Hedge provided if rate goes above ATMF+1%

ATMF

Protection against fall in rates to below ATMF -”Y”

Y

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)

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.

KEY RISKS

The use of derivatives may expose schemes to additional

risks. Please see the Key Risks information on page 7.

Source: LGIM Source: LGIM

60708090

100110120130140150160

0% 1% 2% 3% 4%

No

min

al li

abili

ty v

alu

e

20-year swap rate in 3 years

Unhedged Position Position with Sold Swaption

60708090

100110120130140150160

0% 1% 2% 3% 4%

No

min

al li

abili

ty v

alu

e

20-year swap rate in 3 years

Unhedged Position Position with Zero-Cost Collar

6


Equity options educational refresher

EQUITY OPTIONS EDUCATIONAL REFRESHERImplied 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.

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

KEY RISKS

The use of derivatives may expose schemes to additional

risks. Please see the Key Risks information on page 7.

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.

60%

70%

80%

90%

100%

110%

120%

130%

140%

150%

60% 80% 100% 120% 140%

Price Index 90% Floor

90% put payoff (ignoring premium) (for illustrative purposes only)

Source: LGIM

60%

70%

80%

90%

100%

110%

120%

130%

140%

150%

50% 70% 90% 110% 130%

Price Index Zero-Cost Put Spread Collar

90/70 put spread payoff (ignoring premium - for illustrative purposes only)

Source: LGIM

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

60%

70%

80%

90%

100%

110%

120%

130%

140%

150%

50% 70% 90% 110% 130%

Price Index Zero-Cost Put Spread Collar

Zero-cost 90/70 put spread collar payoff (for illustrative purposes only)

Upside participation up to level of “X”

Protection against market falls of between 10% and 30%

X

100

70 90

Source: LGIM

Protection against market falls of between 10% and 30%

100

7090

7


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.

Repo pricing is shown as an annualised fixed funding

cost for 3-month, 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’.

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)

DATA KEY

KEY RISKSDerivatives 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.

8


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.

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 [email protected] [email protected] [email protected] +44 (0)20 3124 3568 +44 (0)20 3124 4247 +44 (0)20 3124 3569

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