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Sweating Your Assets

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  • 1. Redington13-15 Mallow StreetLondon EC1Y 8RDT. 020 7250 3331www.redington.co.ukSweating your AssetsKaren Heaven– Redington8 June 2011
  • 2. • Gilt Repurchase Agreement – “Gilt Repo”• Gilt Total Return Swap – “Gilt TRS”• “Collateral Upgrade Trade” – also known as Collateral Swap orSecured Funding Trade• All are potential opportunities for pension schemes which havearisen following the credit crunch2Introduction
  • 3. Gilt Repo and Gilt TRS
  • 4. -1.5-1.0-0.50.00.51.01.52.02.530yr Inflation-Linked Gilt Yield 30yr Swap Real Yield Swap SpreadReal RatesWhat has happened in the market?Market-driven Opportunity(%)1. Gilt real yield has been calculated as the yield on index-linked gilts: Swap real yield has been calculated as the difference between nominal swap rate and inflation swap rate: Swap spread has been calculated asSwap Yield minus Gilt Yield430y Real Rates(1)Lehman Brothers’collapseSwaps have historicallyyielded higher than GiltsLate 2008 – Gilt / swap spread becomesnegative and remains so today
  • 5. -1.0-0.50.00.51.01.53.03.54.04.55.05.530yr Nominal Swap 30yr Gilt Yield Swap SpreadMarket-driven Opportunity....Same for Nominal RatesSwap and Gilt yields (%)1. Swap spread has been calculated as Swap Yield minus Gilt YieldGilt / Swap Spread(%)Late 2008 – Nominal Gilt / swap spreadbecomes negative and remains so todayLehman Brothers’ collapseNominal RatesWhat has happened in the market?5Nominal swaps havehistorically yieldedhigher than Gilts
  • 6. Why Gilt Repo and Gilt TRS?• Historically , pension schemes have used interest rate and inflation swaps as part of their investmentstrategy, with the advantages of:– Swaps are implemented as an overlay i.e. they are unfunded– They offer flexibility i.e. a scheme could hedge each individual cash flow if required– Relative value: swap rates were previously higher than Gilt yieldsHowever, given the current market dislocation, it would be advantageous to get exposure to the Gilt yield(instead of the swap yield)• Could buy Gilts, but would need to sell other assets to release cash– Affects expected return on assets• Could replace physical equities with synthetic equities (e.g. equity futures) and use the cash released topurchase Gilts– A number of pension schemes have done this transaction since 2008• Another solution is to get exposure to Gilts on an unfunded basis, either via:– Gilt Repo or;– Gilt TRS6
  • 7. 7Comparing Gilts and SwapsHedging using swaps Hedging using giltsUpfront Payment: None Purchase PriceCounterparty Risk: Yes, mostly mitigated with collateralagreementUK Sovereign RiskSeparate Out Interest Rate andInflation Risk:Yes More difficultReal Yield: Historically higher than real yield ongilts for most maturities; currentlythis relationship is invertedHistorically lower than real rate swapsfor most maturities; currently thisrelationship is invertedBasis Risk vs. a Swap Benchmark: No YesBasis Risk vs. a Gilt Based LiabilityValuation:Yes NoBasis Risk vs. a Corporate BondBased Liability ValuationYes YesAdding in Risk/ Return Exposure: Assets of fund can be invested in riskyassetsSynthetic overlay such as equity futuresPosition Size Limited By: Need to post collateral againstpotential negative mark-to-marketNeed to finance purchase price of giltsDocumentation ISDA/CSA N/A
  • 8. •A repo is a transaction where the scheme sells some gilts to a counterparty (1) , and at the same timecommits to repurchase the gilts back at a specified date at a specified price (2)•Although legal title to the gilts is transferred, the Scheme retains the economic benefits and market riskof owning them, thereby achieving financingWhat is a Gilt RepoHedging Nominal RatesGilt Repurchase (“Repo”) AgreementPension SchemeCounterparty e.g.Investment bankReceives Cash (C)Sells Gilts1Pension SchemeCounterparty e.g.Investment bankBuys GiltsPays cash (C + repo interest amount)82
  • 9. What is a Gilt RepoHedging Nominal RatesGilt Repurchase (“Repo”) Agreement9• Gilt repos are transacted under a “Global Master Repurchase Agreement” (GMRA), the standardised repodocumentation, similar in purpose and function to an ISDA agreement for derivatives• Counterparty risk is dealt with via over-collateralisation and daily mark-to-marketREPO LIBOROvernight 0.55333 0.568131 Week 0.55333 0.587752 Week 0.55333 0.597501 Month 0.55500 0.625003 Month 0.58625 0.826256 Month 0.64667 1.105001 Year 0.77667 1.58250Source: Bloomberg, 6 June 2010• From the point of view of the lender of cash, this is a verysecure transaction and therefore current repo rates aresignificantly below LIBOR (see table)• Hence, this offers very attractive financing, withconsiderable flexibility over term, for the borrower• The repo market is deep, liquid and transparent, and, as acornerstone of the money markets, the Bank of Englandprioritised ensuring that it continued to function during theworst days of the financial crisis
  • 10. Comparison: Interest Rate Swap vs. Gilt Financed by RepoSwap(e.g. 30 yr)Pay: 6m LIBORRec: Fixed Rate1.105%13.959%1Gilt Financedby Rolling6m1 RepoPay: 6m Gilt RepoRateRec: Gilt yield0.647%14.142%145.8bp1 advantagefor 1st 6mUnknown LIBOR – REPO spread for remainder of transaction18bp1 advantage on fixed leg for the life of the transaction1 6m period shown for comparisonwith 6m LIBOR. Actual transactionscan be done from overnight tolonger maturitiesIn the following worked example, gilts financed by repo offer a 18bp advantage on the fixed leg as well as a45.8bp on the variable leg when compared to swaps as at 6 June 2011.10Alternative waysGilt financed by Repos
  • 11. Total Return SwapsHedging Nominal Rates• A gilt total return swap (TRS) is an over-the-counter (OTC) contract.• One counterparty (e.g. a bank) agrees to pay the total return (price appreciation + coupons) on aspecified gilt over an agreed period of time, in exchange for receiving a floating payment based onLIBOR, from another counterparty (e.g. a pension scheme) over the same period of time.• The Total Return Swap may be on a conventional gilt or index-linked gilt.Pension Scheme CounterpartyTotal Return (priceappreciation + Coupons)LIBOR +/- Premium11
  • 12. Total Return SwapsHedging Nominal Rates• A gilt TRS is transacted under ISDA documentation (the same documentation that is used for interestrate and inflation swaps).• As is the case for interest rate and inflation swap trades, the gilt TRS is marked to market on a dailybasis, with high quality collateral being passed between the two counterparties12Advantages DisadvantagesPossible regular cashrequirementCounterparty balancesheet chargeRollover RiskAlternative to repoGilt yields higher thanswapsUnfundedAdvantages/Disadvantage of TRS• The TRS counterparty (i.e. a bank) will oftenbuy the gilt and finance it through the repomarket, as described previously.• Crucially, where the counterparty is a bank,this transaction will utilise its balance sheetand hence a charge will likely be incurred toreflect this.• Therefore, Schemes who are able and willingto set up the necessary documentation andmanagement of repo transactions canexperience better economics than those whouse total return swaps
  • 13. Comparison: Gilt Financed by Repo vs. Gilt Total Return Swap13Gilt Financedby Rolling6m(1) RepoPay: 6m Repo RateRec: Gilt yield0.647%4.142%(1) 6m period shown for comparison with 6mLIBOR. Actual transactions can be donefrom overnight to longer maturitiesGilt TotalReturn Swap(e.g. 2 yr)Pay(2): 6m LIBOR[+/-X]bpsRec: Gilt TotalReturn=1.105% -0.18%4.142%Unknown pricing and market capacity of roll-over every 2 yearsPotential cash settlement ofnegative total return(2) Indicative pricing c. Libor – 18bpGilt RepoGilt TRS
  • 14. 14Repo Gilt TRSLiquidity • Excellent for shorter maturities• Variable for longer maturities• Considerable variation from bank to bank andaccording to market conditions• Over 1 year significantly more expensive thanless than 1 yearMaturity • Majority of activity is in overnight up to3 months• Longer dates out to one year transactwith variable liquidity• Typically 1 year• Potentially 2 – 3 yearsRoll-over • Expected to be excellent as the repomarket is cornerstone of Bank ofEngland’s money market operations• Long maturities may not trade in a crisis• Pricing at rollover dependent on counterparty’scapacity and balance sheet charges (TRSconsumes the counterparty’s balance sheet)• Risk of market liquidity collapsing if there arerenewed banking sector problemsGilt Repos vs. Gilt Total Return Swap - Considerations
  • 15. 15Repo Gilt TRSTransparency • Very good pricing information - onbroker screens• May be unreliable for long maturities /in a crisis• No publicly available pricing sources• Varies considerably from bank to bankDocumentation • GMRA – similar to ISDA• Negotiations will involve time andexpense• ISDA & CSA (existing) – for schemes with thisin place, TRS may be more convenient thanGilt RepoCollateral(subject tocounterparty)• Gilts• Daily mark-to-market• Cash, gilts and in some cases other securities• Mark-to-market frequency and collateralthresholds subject to CSAsGilt Repos vs. Gilt Total Return Swap - Considerations
  • 16. Collateral Upgrade Trades
  • 17. What is a Collateral Upgrade Trade?What is a Collateral Upgrade Trade?• A Collateral upgrade trade is a transaction whereby a Pension Scheme loans Gilts to a bank in return forless liquid collateral plus a fee.• This trade can be structured in a number of ways, including:– A cash investment– Yield enhancing portfolio swap• Through a variety of structures:– Securities Lending Agreements (SLA)– Total Return Swaps (TRS)– Collateral Swaps– Repo-facilities• Each type of structure has its own advantages and disadvantages, and within the different structures, thedetails of the trades are entirely bespoke and are agreed between the bank and the pension scheme.17
  • 18. Why do a Collateral Upgrade Trade?Why enter into this transaction?• Pension scheme: to earn additional returns on Gilt portfolio.– The transaction monetises the “illiquidity premium”. As long-term investors, Pension Schemes do notnecessarily need to hold all of their assets in very liquid instruments (as long as benefit payments andcollateral requirements (e.g. for swaps) can be met).• Bank: to gain liquidity, which is now at a premium for banks, primarily due to incoming Basel III rules.Banks may also be unwilling to sell their illiquid assets as the market for some structured assets remainsdepressed.Who is this transaction for?• Currently for larger pension schemes because :– Transactions are entirely bespoke , hence negotiating terms with banks can be time-consuming andcostly– Can only be undertaken on an individual scheme basis; there is no pooled fund format for this– As a rule of thumb, c.£100m is a minimum transaction size, although greater optionality in thestructuring could be achieved for larger sizesIllustration• For simplicity, we illustrate Collateral Upgrade Trades using “Securities Lending Agreements” (SLA); themost common and simplest structure in which a Collateral Upgrade Trade can be done.18
  • 19. Collateral Upgrade TradeDiagrammatic Overview - SLA19Pension Scheme Bank1. Pension Scheme lends [£200m] of Gilts to bank2. Investor receives [X bps] in return3. Bank posts [£220m - £260m] worth of “assets” as collateralPension Scheme BankStep 2:4. Dividend/interest from collateral isreturned to bank5. (Structure dependant) Any “Yield”from gilts is returned to the InvestorBanks are only seeking tofund their assets, not sellthem. As such, banks willwant to retain economicexposure to theircollateral. Banks could dothis in a number of ways,but one such concept isshown here.It is crucial to determinewhat types of asset willform the collateral beforeentering into such anagreement.Step 1:
  • 20. Collateral Upgrade TradeSecurity Lending Agreement – Basic PrincipalsSecurities Lending Agreement (SLA) – Basic PrincipalsSecurities lending involves the legal transfer of securities, such as gilts, to a counterparty (e.g. bank), who will inturn provide the lender (e.g. pension scheme), with collateral, typically in the form of illiquid assets.The bank pays the lender a fee (upfront or periodically) and is contractually obliged to return the securitiesborrowed from the lender upon maturity.Depending on the agreement, the bank may transfer back any interest/dividend payments on the gilts to thelender or incorporate them into the “fee”. Likewise the interest/dividend payments on the collateral is returnedto the bank.The collateral posted with the pension scheme will usually be subject to a “haircut” i.e. the collateral’s marketvalue will be higher than the value of the securities lent to the bank – it is “over-collateralised”. The “haircut”applied to the collateral depends on the quality of the assets posted.In general securities lending agreements are governed by a Global Master Securities Lending Agreement(GMSLA).20
  • 21. High Level Benefits and Risks of Collateral Upgrade TradeBased on Security Lending AgreementBenefits• Yield Enhancement: Pension Schemereceives a negotiated fee.• Over-Collateralisation: Pension Schemeholds collateral with a higher market valuethan that of the assets (Gilts) it has lent.• Eventual Return of Assets: PensionScheme receives its assets back atmaturity. Same appplies to bank.Risks• Counterparty Risk: Borrower mightdefault• Collateral Risk: Risk that the value of thecollateral falls below the replacement costof the securities that are lent (exactprotocol for collateral is up fornegotiation)• Collateral Requirements: Investorsinvolved in other derivatives hold areserve of “liquid assets” to service anypotential collateral calls. A new trademight deplete this reserve.21
  • 22. Collateral Upgrade Trade – Considerations for the Pension SchemeCollateral Upgrade Trades are entirely bespoke; the following are some of the structuring considerations for apension scheme• Is this type of transaction consistent with your investment strategy and objectives?• What is the credit rating of the bank you are lending Gilts to?• What value of Gilts should be lent and for how long?– Consider impact on liquidity collateral requirements for the whole scheme• What types of assets are you willing to accept as collateral and why?– Can they be independently valued?– Consider risk management implications and action in the event of borrower default.• How much of one type of collateral are you prepared to accept? What limits should be placed on any singleasset class?• What level of “over-collateralisation” is required? 110%, 130%? Will it be enough to mitigate large marketfluctuations?• What other risks are you potentially exposed to in this type of transaction e.g. collateral switching at thebank’s option?• What measures can be implemented that help ensure that the value of the collateral held doesn’t decrease?22
  • 23. Sovereign Bonds•Senior unsecured debt•Varying levels of credit ratingsdepending on issuing government•Includes quasi-governmentalbonds such as supranationalbonds – issued by institutions suchas the European Investment Bankand the World BankCorporate Bonds•Senior unsecured debt•Varying levels of credit ratingsdepending on issuing company•Corporate bonds originate fromvarying sectors:•Financials•Non-financials•Telecoms & utilities, etc.Covered Bonds•Senior secured debt•Very similar to asset backedsecurities except that the assetsremain on issuer’s balance sheet.•Bonds are backed by a “coveredpool” of assets:•Mortgages Loans•Public Sector Loans23Securitised Debt & Structured Credit•Senior/ junior securitised debt•Predominantly Asset Backed Securities:•Consumer Credit – backed by underlyingpool of consumer receivables (i.e. autoloans, credit card payments etc...)•Commercial Mortgage – backed byunderlying pool of commercial mortgages.•Residential Mortgages – backed by anunderlying pool of residential mortgages.Loans•Senior secured debt, typical examples include:•Large Cap Loans – loans to large corporations•SME Loans – loans to small/medium corporations•Export Credit Agreements (ECA) – quasi government backed loansused by companies to buy items such as planes.•Education Loans – consists of loans to Higher Education institutions.•Private Finance Initiative (PFI) – private financing to Governmentprocurement and infrastructure projects.•Social Housing Loans – loans to social housing developers/operatorsExamples of Types of Collateral Offered
  • 24. Liquidity and Collateral ConsiderationsAddition considerations – Collateral Requirements•Pension funds generally hold a reserve of “liquid assets” to service any potential collateral calls arising from theirexisting derivative trades, and separately to pay benefits as they fall due.•It is therefore crucial for pension funds to understand the implications entering into any funding/liquidity tradewill have on this reserve, as the basis of such trades involves pension funds foregoing access to some of their liquidassets a for pre-determined time.0100200300400500600700Collateral Requirements Avaliable CollateralGBPMillionsCollateral RequirementsConventional Gilts Inex-linked Gilts + Asset Swaps 1 Year VaR of Swaps 1 Year of VaR of Gilts0100200300400500600700Collateral Requirements Avaliable CollateralGBPMillionsCollateral RequirementsConventional Gilts Inex-linked Gilts + Asset Swaps 1 Year VaR of Swaps 1 Year of VaR of Gilts24
  • 25. 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 ofmarket 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 beduplicated 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 otherreference 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 .Redington Ltd 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 purposesand 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 oftax, accounting, law or of any other nature), should be treated as illustrative only and not relied upon as accurate.©Redington Limited 2011. All rights reserved. No reproduction, copy, transmission or translation in whole or in part of this presentation may be made without permission. Application for permission shouldbe made to Redington Limited at the address below.Redington Limited (reg no 6660006) is registered in England and Wales. Registered office: 13-15 Mallow Street London EC1Y 8RDTHE DESTINATION FOR ASSET & LIABILITY MANAGEMENTContactsDisclaimerDirect Line: +44 (0) 20 3326 7134Telephone: +44 (0) 20 7250 3331Redington13-15 Mallow StreetLondon EC1Y 8RDKaren HeavenVice President | Investment Consultingkaren.heaven@redington.co.ukwww.redington.co.uk25

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