4. Transaction: 2004-2006.
Sponsor top-up +
interest rate and
inflation swaps.
The First Holistic
LDI Transaction
Transaction: Dec 2003.
Long-dated interest
rate and inflation
swaps.
Transaction: 2001 to 2004.
Equity to bond switch +
inflation swaps.
Transaction: Sep 2005.
Exchange equities and
fixed income
instruments for swaps
and equity options
2002: Adaption
of FRS17 (UK)
Explosion of asset managers
offering LDI solutions, e.g.
pooled/segregated funds.
LDI strategies take off. In the first half of
2008 LDI assets had increased 27%.
2001 2002 2003 2004 2005 2006 2007 2008 2009
Conversion
of Swap/Gilt
Yield
Hedging un(der)rewarded Risk
LDI Evolution
Inversion of
Swap/Gilt
Yield
?
Pensions Act & IAS
19 Amended
6. Hedging un(der)rewarded Risk
Swaps – The Practicalities
6
Main Considerations
ISDA and CSA Documentation
• Master agreement, schedule, confirmation.
Trading / Best Execution
• Consistent pricing.
Counterparty Risk
Cash Management and Collateralization
• Frequency of collateral calls, quality of collateral, haircut.
Valuation / Accounting / Reporting
Costs
• Bid/offer spread, opportunity cost, slippage, advisory, legal, custodian.
Compliance
7. Market Challenges
Hedging un(der)rewarded Risk
Evolution of LDI Implementation
• Reduced liquidity
• Inability to deal across the curve;
• Banks reluctant to transact large volumes.
• Counterparty failure
• Bear Stearns, Lehman Brothers.
• Wider spreads
• Need for new execution methods / strategy
Historical Nominal Swap Rates
Historical Inflation (RPI) Swap Rates
Source: Bloomberg / Redington
8. Managing Counterparty Risks
• Only transact with high-quality counterparties, i.e. those with strong long-term credit ratings.
• Reduce time between mark-to-market, i.e., arrange weekly or daily collateral support agreement, set
threshold (requires ISDA and CSA in place with each counterparty).
8
Hedging un(der)rewarded Risk
Counterparty Analysis
5 Year Senior Debt Credit Default Swap (CDS) Levels
Source: Bloomberg / Redington
10. 10
The Evolution of LDI Implementation
2007 2008
Services Asset Manager* Redington + ?
Portfolio construction
ISDA negotiations
Daily pricing grids
Counterparty selection
Dealing band analysis Sometimes
Execution of swap programme Asset Manager
Execution reports Sometimes
Ongoing portfolio
monitoring/rebalancing
Libor generating assets Asset Manager
2009
*Some items will have been done in conjunction with scheme’s investment advisor
Hedging un(der)rewarded Risk
Evolution of LDI Implementation
12. Step 8: Solution Monitoring
Step 7: Execution monitoring
Step 6: Accessing market “axes” and opportunistic hedging
Step 5: Appropriate Dealing costs
Step 4: Optimal transaction size(s)
Step 3: Optimal timing of execution
Step 2: Framework to minimise market impact
Step 1: Establish a Working Party to make tactical execution decisions based on current market levels
12
Hedging un(der)rewarded Risk
Implementation Framework - Eight Steps
13. Hedging un(der)rewarded Risk
Liability Cash Flows
• An important part of our analysis is
the reverse engineering of the
pension scheme’s actuarially
approved cash flows (opposite).
• We re-run the raw data with a wide
range of mortality, wage, inflation
and interest rate assumptions to
ensure that the proposed swap
portfolio is fully optimised.
Detailed Cash Flow and (PV01) Modelling
* The intention of this material is simply to illustrate the type of analysis that can and should, in our view, be carried out in order to help formulate a clear strategy for funding,
risk management and asset allocation. You should not rely upon any calculations or numbers as correct. They are obtained from limited publicly available information and
are for illustration purposes only.
13
14. • Swap prices are received from the trading desk on a
daily basis;
• Real time trading spreads for both interest rate and
inflation swaps are established;
• Dealing costs across different trade sizes and maturities
are covered;
• A comprehensive picture of genuine axes across the
yield curve is built;
• Investment bank works with trustees and Redington to
ensure we can source swaps around points of super
liquidity, allowing access to large PV01 at attractive
dealing spreads.
Pre-trade Execution Process – Daily Pricing Grids
Hedging un(der)rewarded Risk
Step 1: Framework to Minimise Market Impact
14
Indicative pricing for IRS swaps
Tradeweb
Bloomberg
SuperDerivatives
31-Oct-08 PV01 £'000s
IRS 50 100 250 500 750 1000
2y 0.380 0.38 1.00 1.50 1.75 2.00
5y 0.380 0.38 1.00 1.50 1.75 2.00
10y 0.380 0.38 1.00 1.50 1.75 2.00
12y 0.380 0.38 1.00 1.50 1.75 2.00
15y 0.380 0.38 1.00 1.50 1.75 2.00
20y 0.380 0.38 1.00 1.50 1.75 2.00
25y 0.380 0.38 1.00 1.50 1.75 2.00
30y 0.380 0.38 1.00 1.50 1.75 2.00
50y 0.380 0.38 1.00 1.50 1.75 2.00
15. 15
RPI Sample Swap Pricing Grids – increased dealing spreads
31-Oct-07 PV01 £'000s
RPI 50 100 250 500 750 1000
2y 0.500 1.000 1.500 2.250 2.750 3.500
5y 0.500 1.000 1.500 2.250 2.750 3.500
10y 0.500 1.000 1.500 2.250 2.750 3.500
12y 0.500 1.000 1.500 2.250 2.750 3.500
15y 0.500 1.000 1.500 2.250 2.750 3.500
20y 0.500 1.000 1.500 2.250 2.750 3.500
25y 0.500 1.000 1.500 2.250 2.750 3.500
30y 0.500 1.000 1.500 2.250 2.750 3.500
50y 0.500 1.000 1.500 2.250 2.750 3.500
31-Oct-08 PV01 £'000s
RPI 50 100 250 500 750 1000
2y 25.000 25.000 30.000 35.000 40.000 40.000
5y 15.000 16.000 17.000 18.000 19.000 20.000
10y 15.000 16.000 17.000 18.000 19.000 20.000
12y 15.000 16.000 17.000 18.000 19.000 20.000
15y 15.000 16.000 17.000 18.000 19.000 20.000
20y 15.000 16.000 17.000 18.000 19.000 20.000
25y 10.000 11.000 12.000 13.000 14.000 15.000
30y 1.000 1.500 2.000 2.500 3.000 4.000
50y 0.500 1.000 1.500 2.500 3.500 4.500
• Over the last few months, significant pricing differentials have developed among market
participants.
• Some banks are unwilling to openly quote in large volumes at the short end of the curve.
• For longer maturities, market axes continue to keep spreads tight.
Hedging un(der)rewarded Risk
Step 1: Framework to Minimise Market Impact
17. Progress to Fully Hedged
17
• Redington and the investment bank will advise where it may be advantageous
to pay a tighter spread for a proposed swap given the absolute level of yields
available, as well as tactical considerations.
• Investment banks shall meet exacting pricing and execution standards in order
to remain a preferred counterparty.
• Redington will advise whether:
• The Present Value implied by the transaction on offer is
appropriate/within a pre-defined trading band;
• The proposed spread charge is appropriate to the size of the
transaction and the absolute level of the market;
• There is a stable market;
• There are any other factors to consider.
• Redington will make a recommendation as to whether is appropriate to
execute.
• To date we have helped clients achieve substantial savings in hedging
PV01 as a result of:
• Using our relationships with banks’ trading desks;
• Helping clients improve their governance structure.
Appropriate Dealing Costs
Accessing market “axes” and opportunistic hedging
Following the Market
• There is no single optimal transaction size – it will depend on market
conditions;
• Continuously survey views and sentiment of interest and inflation traders;
• Track macroeconomic factors affecting liquidity (supply and demand).
Hedging un(der)rewarded Risk
Step 4-6: Optimal Transaction Size, Dealing Costs, Market “Axes”
19. Execution Monitoring
On the proposed day(s) for executing, the Investment
Manager approaches the investment bank for information on
whether the pricing is consistently competitive in the desired
maturities and on the combined switch package. A complete
monitoring process should carry the following features:
During Trading – Trader should find the real market mid
price, guaranteeing that other banks are not pushing market
mid because they know of the trade (information leakage).
Real Time Pricing – After every trade, verify the transaction
report and check pricing obtained against independent pricing
sources i.e. Bloomberg and TradeNet.
Independent Review – At the end of the switching
programme, it is recommended to carry through an
independent review of the asset manager’s performance in
order to ensure that the required level of governance has been
reached.
Risk Management – Ongoing risk management will require
constant access to holdings, positions, regular reporting,
collateral management and an alert system.
19
Hedging un(der)rewarded Risk
Step 7: Execution Monitoring
20. * The intention of this material is simply to illustrate the type of analysis that can and should, in our view, be carried out in order to help formulate a clear strategy for funding, risk management
and asset allocation. You should not rely upon any calculations or numbers as correct. They are obtained from limited publicly available information and are for illustration purposes only.
• Once a solution is in place, monitoring is key to track the evolution of the pension fund and the solution’s
performance. The pension fund should be well informed so that it may adjust its position if necessary.
• Redington is in the unique position that it can deliver ongoing analysis of both the pension fund and the
solutions implemented. It works with clients and asset managers to adjust the hedging programme on a
yearly basis (or as required).
• Operational Monitoring – Daily reconciliations between swap counterparty and custodian, an independent
valuation agent can also be involved.
• Compliance Reporting – Independent compliance reports to the Plan on a quarterly basis on key findings.
Compliance reporter will work closely with the Internal Audit Department to ensure portfolio managers’
continued compliance with client investment guidelines, in management, operations and legal teams.
Solution Monitoring
Daily monitoring
• Independent Valuation Check
• Verification (Comparison with appropriate
market)
• Counterparty Credit Monitoring Tool
Ongoing management
• Monthly Reporting
• Scenario Analysis
• Rebalance Analysis
Example of Ongoing Monitoring and Management
Hedging un(der)rewarded Risk
Step 8: Solution Monitoring
20
22. 22
What happens when a swap counterparty vanishes?
Mark-to-Market
(MTM) of
Outstanding
Swaps
• Determine exact moment of bankruptcy:
• Value outstanding collateral;
• Obtain 5 bank Quotes to value all outstanding swap positions;
• Or determine “Loss”.
Determine net
payment flows
• Net all outstanding swap contracts with bankrupt counterparty.
•If net payments owed to pension fund, collateral claimed.
•If collateral insufficient, shortfall is unsecured claim in bankruptcy.
•If net payments owed to counterparty, pension fund releases
collateral to counterparty.
New
Swaps/Hedges
•Execute new replacement swaps at current market levels; or
•Buy bonds (Government/inflation) wait for more favourable market
conditions.
•Do nothing - Run market risk.
Swap Collateral
Investment Banks
• Provided clients with a poll of swap
prices to help determine close out levels
with Lehman.
• Made markets on replacement trades
for clients.
• Lehman was not a major LDI
counterparty but some estimates
suggest they had over £3m PV01 of
RPI exposure, and much more in
nominals.
• On Monday, 15 Sep ‘08, an estimated
50% to 60% of this was traded, which
pushed swap break-evens 10bps
higher.
Hedging un(der)rewarded Risk
Implication of Lehman’s Failure – Case Study
23. 23
What are the key risks / costs associated with replacing a swap?
• Potential shortfall
between value of
collateral and MTM of
swap value;
• Bid / offer spread
charged on replacement
transaction;
• Open market risk from
time of bankruptcy until
new hedge
implemented;
• Availability of
replacement swap given
illiquid market
conditions.
Breakevens implied by swaps were
sharply higher in the long end with 30yrs
trading at the psychologically important
4.00% level (up 11bps on the day).
Replacement of Lehman Risk (est.) in the Market (change in RPI Swap Curve)
Source: Bloomberg / Redington
Hedging un(der)rewarded Risk
Implication of Lehman’s Failure – Case Study
24. 24
Source: Bloomberg / Redington
CDO crisis
Northern Rock
nationalised
Bear Sterns bought
out by JP Morgan
Lehman Brothers
file for
bankruptcy. Fed
leave short term
rates unchanged
Overnight GBP Libor
Hedging un(der)rewarded Risk
Implication of Lehman’s Failure – Case Study
25. 25
Managing Counterparty Risk
1. Minimise exposure through tightening CSA conditions
• Credit risk can be reduced by:
• Reducing the time between collateral calls;
• Limiting the types of securities that can be posted as collateral to cash and government bonds;
• Reducing minimum collateral thresholds to zero.
2. Re-coupon swap transactions to current mid-market value
• Swap transaction terms should be regularly “updated” such that the hedging bank pays an upfront cash
amount to the pension plan, thereby reducing the prevailing mark-to-market value to (or close to) zero, i.e.,
it settles up its account;
• For this to work, swaps should be re-couponed to have broadly the same interest rate and inflation
sensitivity as previously;
• This frees up cash to invest in assets to generate a return above LIBOR, and reduces credit exposure to swap
counterparty.
3. Novate or assign swaps to new swap counterparties
• Pension fund completely replaces hedging bank counterparty in swap agreement. New swap counterparty
executes "back to back" swap with old swap counterparty.
Hedging un(der)rewarded Risk
Counterparty Risk
27. Synthetic (Unfunded) Assets
Equity Futures
iTraxx/CDS
Nominal Swaps
RPI Swaps
Cash (Funded) Assets
Equities
Corporate Bonds
UK Gilts
Index Linked Gilts
Tactical
Switch
27
What Lies Ahead? - Dynamic Active LDI Strategy
• Implementing an LDI strategy is not a one-off decision;
• As markets move there is relative value between cash and synthetic assets;
• A pension scheme can profit from this without losing the hedging or return properties of the
strategic LDI target;
• Tactical switches in one component are limited by the manager’s ability to free up cash whilst
maintaining the risk exposure in remaining components.
Hedging un(der)rewarded Risk
LDI 2008 and Beyond
Longevity Swaps
28. 28
What is driving the current environment
Prior to this point swaps
were preferable to gilts;
since then the situation
has reversed.
• “Flight to quality” has meant
a rush to buy short dated
gilts, not long dated linkers
(short swap spreads are still
very positive, over 100bps);
• Lack of inflation supply in
swap market, coupled with
continued high demand from
pension funds, has caused
swap inflation to become
expensive relative to gilt
inflation;
• Expectation of increased gilt
issuance due to increasing
fiscal pressures has led to
general cheapening of gilts;
• General lack of funding in the
financial system has meant
reduced appetite for holding
bonds that need to be
financed.
• “Real” 30 year swap spread is the difference in yield between the 30 year real rate zero
coupon swap and the 2037 index-linked gilt;
• Although the extreme anomaly observed at the long end of the real yield curves has begun
to reverse, it remains desirable to take advantage of the phenomenon whereby long-term
gilt real yields exceed those of swaps.
Hedging un(der)rewarded Risk
LDI 2008 and Beyond
29. 29
Generating LIBOR + Returns
Hedging un(der)rewarded Risk
LDI 2008 and Beyond
UK
Government
long dated
Linker
Pension
Scheme
Bank
Inflation-linked coupon +
Redemption
Inflation-linked coupon +
Redemption
Initial Principal Libor + xx bps + Principal
30. 30
Current Opportunities
Hedged / Partial Hedged
Schemes
• Buy nominal / index-linked gilts
• Switch from swaps into
nominal / index-linked gilts for:
• Yield pickup;
• Reduction in
counterparty risk.
• Retain swaps and enter asset
swap to lock in ‘Libor plus’
returns
Unhedged Schemes
• Buy nominal / index-linked gilts
(to roughly match the duration
and characteristic of scheme
liabilities);
• Actively monitor market and
portfolio.
• The swap spread reached a low of over minus 120 basis points but has rebounded as some
investors have increased their allocation to index-linked gilts.
Hedging un(der)rewarded Risk
LDI 2008 and Beyond
34. Contacts
Dawid Konotey-Ahulu | Partner Direct: +44 (0) 207 250 3415
dawid@redingtonpartners.com
Robert Gardner | Partner Direct: +44 (0) 207 250 3416
robert.gardner@redingtonpartners.com
Redington Partners LLP
13 -15 Mallow Street London EC1Y 8RD
Telephone: +44 (0) 207 250 3331
www.redingtonpartners.com
THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT
Contacts
Disclaimer
Disclaimer For professional investors only. Not suitable for private customers.
The information herein was obtained from various sources. We do not guarantee every aspect of its accuracy. The information is for your private information and is for discussion
purposes only. A variety of market factors and assumptions may affect this analysis, and this analysis does not reflect all possible loss scenarios. There is no certainty that the
parameters and assumptions used in this analysis can be duplicated with actual trades. Any historical exchange rates, interest rates or other reference rates or prices which appear
above are not necessarily indicative of future exchange rates, interest rates, or other reference rates or prices. Neither the information, recommendations or opinions expressed
herein constitutes an offer to buy or sell any securities, futures, options, or investment products on your behalf. Unless otherwise stated, any pricing information in this message is
indicative only, is subject to change and is not an offer to transact. Where relevant, the price quoted is exclusive of tax and delivery costs. Any reference to the terms of executed
transactions should be treated as preliminary and subject to further due diligence .
Please note, the accurate calculation of the liability profile used as the basis for implementing any capital markets transactions is the sole responsibility of the Trustees' actuarial
advisors. Redington Partners will estimate the liabilities if required but will not be held responsible for any loss or damage howsoever sustained as a result of inaccuracies in that
estimation. Additionally, the client recognizes that Redington Partners does not owe any party a duty of care in this respect.
Redington Partners are investment consultants regulated by the Financial Services Authority. We do not advise on all implications of the transactions described herein. This
information is for discussion purposes and prior to undertaking any trade, you should also discuss with your professional tax, accounting and / or other relevant advisers how
such particular trade(s) affect you. All analysis (whether in respect of tax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as
accurate.
34
