sweating your assets 1dfdf

7/29/2019 Sweating Your Assets 1dfdf

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Redington

13-15 Mallow Street

London EC1Y 8RD

T. 020 7250 3331

www.redington.co.uk

Sweating your AssetsKaren Heaven Redington

8 June 2011


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Gilt Repurchase Agreement Gilt Repo

Gilt Total Return Swap Gilt TRS

Collateral Upgrade Trade also known as Collateral Swap or

Secured Funding Trade

All are potential opportunities for pension schemes which have

arisen following the credit crunch

2

Introduction


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Gilt Repo and Gilt TRS


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-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

30yr Inflation-Linked Gilt Yield 30yr Swap Real Yield Swap Spread

Real Rates

What 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 as

Swap Yield minus Gilt Yield4

30y Real Rates(1)

Lehman Brothers

collapse

Swaps have historically

yielded higher than Gilts

Late 2008 Gilt / swap spread becomes

negative and remains so today


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-1.0

-0.5

0.0

0.5

1.0

1.5

3.0

3.5

4.0

4.5

5.0

5.5

30yr Nominal Swap 30yr Gilt Yield Swap Spread

Market-driven Opportunity....Same for Nominal Rates

Swap and Gilt yields (%)

1. Swap spread has been calculated as Swap Yield minus Gilt Yield

Gilt / Swap Spread(%)

Late 2008 Nominal Gilt / swap spread

becomes negative and remains so today

Lehman Brothers collapse

Nominal Rates

What has happened in the market?

5

Nominal swaps have

historically yielded

higher than Gilts


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Why Gilt Repo and Gilt TRS?

Historically , pension schemes have used interest rate and inflation swaps as part of their investment

strategy, 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 yields

However, 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 to

purchase 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 TRS

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7

Comparing Gilts and Swaps

Hedging using swaps Hedging using gilts

Upfront Payment: None Purchase Price

Counterparty Risk: Yes, mostly mitigated with collateral

agreement

UK Sovereign Risk

Separate Out Interest Rate and

Inflation Risk:

Yes More difficult

Real Yield: Historically higher than real yield on

gilts for most maturities; currently

this relationship is inverted

Historically lower than real rate swaps

for most maturities; currently this

relationship is inverted

Basis Risk vs. a Swap Benchmark: No Yes

Basis Risk vs. a Gilt Based Liability

Valuation:

Yes No

Basis Risk vs. a Corporate Bond

Based Liability Valuation

Yes Yes

Adding in Risk/ Return Exposure: Assets of fund can be invested in riskyassets

Synthetic overlay such as equity futures

Position Size Limited By: Need to post collateral against

potential negative mark-to-market

Need to finance purchase price of gilts

Documentation ISDA/CSA N/A


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A repo is a transaction where the scheme sells some gilts to a counterparty (1) , and at the same time

commits 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 risk

of owning them, thereby achieving financing

What is a Gilt Repo

Hedging Nominal Rates

Gilt Repurchase (Repo) Agreement

Pension Scheme Counterparty e.g.Investment bank

Receives Cash (C)

Sells Gilts1

Pension SchemeCounterparty e.g.

Investment bank

Buys Gilts

Pays cash (C + repo interest amount)

8

2


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What is a Gilt Repo


Gilt Repurchase (Repo) Agreement

9

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-market

REPO LIBOROvernight 0.55333 0.56813

1 Week 0.55333 0.58775

2 Week 0.55333 0.59750

1 Month 0.55500 0.62500

3 Month 0.58625 0.82625

6 Month 0.64667 1.10500

1 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 are

significantly below LIBOR (see table)

Hence, this offers very attractive financing, with

considerable flexibility over term, for the borrower

The repo market is deep, liquid and transparent, and, as a

cornerstone of the money markets, the Bank of Englandprioritised ensuring that it continued to function during the

worst days of the financial crisis


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Comparison: Interest Rate Swap vs. Gilt Financed by Repo

Swap

(e.g. 30 yr)

Pay: 6m LIBOR

Rec: Fixed Rate

1.105%1

3.959%1

Gilt Financed

by Rolling

6m1 Repo

Pay: 6m Gilt Repo

Rate

Rec: Gilt yield

0.647%1

4.142%1

45.8bp1 advantage

for 1st 6m

Unknown LIBOR REPO spread for remainder of transaction

18bp1 advantage on fixed leg for the life of the transaction1 6m period shown for comparison

with 6m LIBOR. Actual transactions

can be done from overnight to

longer maturities

In the following worked example, gilts financed by repo offer a 18bp advantage on the fixed leg as well as a

45.8bp on the variable leg when compared to swaps as at 6 June 2011.

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Alternative waysGilt financed by Repos


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Total Return Swaps


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 a

specified gilt over an agreed period of time, in exchange for receiving a floating payment based on

LIBOR, 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 Counterparty

Total Return (price

appreciation + Coupons)

LIBOR +/- Premium

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Total Return Swaps


A gilt TRS is transacted under ISDA documentation (the same documentation that is used for interest

rate and inflation swaps).

As is the case for interest rate and inflation swap trades, the gilt TRS is marked to market on a daily

basis, with high quality collateral being passed between the two counterparties

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Advantages Disadvantages

Possible regular cashrequirement

Counterparty balancesheet charge

Rollover Risk

Alternative to repo

Gilt yields higher thanswaps

Unfunded

Advantages/Disadvantage of TRS

The TRS counterparty (i.e. a bank) will often

buy the gilt and finance it through the repomarket, as described previously.

Crucially, where the counterparty is a bank,

this transaction will utilise its balance sheet

and hence a charge will likely be incurred to

reflect this.

Therefore, Schemes who are able and willing

to set up the necessary documentation and

management of repo transactions can

experience better economics than those who

use total return swaps


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Comparison: Gilt Financed by Repo vs. Gilt Total Return Swap

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Gilt Financed

by Rolling

6m(1) Repo

Pay: 6m Repo Rate

Rec: Gilt yield

0.647%

4.142%

(1) 6m period shown for comparison with 6m

LIBOR. Actual transactions can be done

from overnight to longer maturities

Gilt Total

Return Swap

(e.g. 2 yr)

Pay(2): 6m LIBOR

[+/-X]bps

Rec: Gilt TotalReturn

=1.105% -

0.18%

4.142%

Unknown pricing and market capacity of roll-

over every 2 years

Potential cash settlement of

negative total return

(2) Indicative pricing c. Libor 18bp

Gilt Repo

Gilt TRS


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Repo Gilt TRSLiquidity Excellent for shorter maturities

Variable for longer maturities

Considerable variation from bank to bank and

according to market conditions

Over 1 year significantly more expensive than

less than 1 year

Maturity Majority of activity is in overnight up to

3 months

Longer dates out to one year transact

with variable liquidity

Typically 1 year

Potentially 2 3 years

Roll-over Expected to be excellent as the repo

market is cornerstone of Bank of

Englands money market operations

Long maturities may not trade in a crisis

Pricing at rollover dependent on counterpartys

capacity and balance sheet charges (TRS

consumes the counterpartys balance sheet)

Risk of market liquidity collapsing if there are

renewed banking sector problems

Gilt Repos vs. Gilt Total Return Swap - Considerations


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Repo Gilt TRSTransparency Very good pricing information - on

broker screens

May be unreliable for long maturities /

in a crisis

No publicly available pricing sources

Varies considerably from bank to bank

Documentation GMRA similar to ISDA

Negotiations will involve time andexpense

ISDA & CSA (existing) for schemes with this

in place, TRS may be more convenient than

Gilt Repo

Collateral

(subject to

counterparty)

Gilts

Daily mark-to-market

Cash, gilts and in some cases other securities

Mark-to-market frequency and collateral

thresholds subject to CSAs

Gilt Repos vs. Gilt Total Return Swap - Considerations


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Collateral Upgrade Trades


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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 for

less 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, the

details of the trades are entirely bespoke and are agreed between the bank and the pension scheme.

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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 not

necessarily need to hold all of their assets in very liquid instruments (as long as benefit payments and

collateral 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 remains

depressed.

Who is this transaction for?

Currently for larger pension schemes because :

Transactions are entirely bespoke , hence negotiating terms with banks can be time-consuming and

costly

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 the

structuring could be achieved for larger sizes

Illustration

For simplicity, we illustrate Collateral Upgrade Trades using Securities Lending Agreements (SLA); the

most common and simplest structure in which a Collateral Upgrade Trade can be done.

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Collateral Upgrade Trade

Diagrammatic Overview - SLA

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Pension Scheme Bank

1. Pension Scheme lends [200m] of Gilts to bank

2. Investor receives [X bps] in return

3. Bank posts [220m - 260m] worth of assets as collateral

Pension Scheme Bank

Step 2:

4. Dividend/interest from collateral is

returned to bank

5. (Structure dependant) Any Yield

from gilts is returned to the Investor

Banks are only seeking to

fund their assets, not sell

them. As such, banks will

want to retain economic

exposure to their

collateral. Banks could do

this in a number of ways,

but one such concept is

shown here.

It is crucial to determine

what types of asset will

form the collateral before

entering into such an

agreement.

Step 1:


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Collateral Upgrade Trade

Security Lending Agreement Basic Principals

Securities Lending Agreement (SLA) Basic Principals

Securities 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 collaterals marketvalue will be higher than the value of the securities lent to the bank it is over-collateralised. The haircutapplied 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).

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High Level Benefits and Risks of Collateral Upgrade Trade

Based on Security Lending Agreement

Benefits

Yield Enhancement: Pension Scheme

receives a negotiated fee.

Over-Collateralisation: Pension Scheme

holds collateral with a higher market value

than that of the assets (Gilts) it has lent.

Eventual Return of Assets: Pension

Scheme receives its assets back at

maturity. Same appplies to bank.

Risks

Counterparty Risk: Borrower might

default

Collateral Risk: Risk that the value of the

collateral falls below the replacement cost

of the securities that are lent (exact

protocol for collateral is up for

negotiation)

Collateral Requirements: Investors

involved in other derivatives hold a

reserve of liquid assets to service any

potential collateral calls. A new trade

might deplete this reserve.

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Collateral Upgrade Trade Considerations for the Pension Scheme

Collateral 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 single

asset class?

What level of over-collateralisation is required? 110%, 130%? Will it be enough to mitigate large market

fluctuations? What other risks are you potentially exposed to in this type of transaction e.g. collateral switching at the

banks option?

What measures can be implemented that help ensure that the value of the collateral held doesnt decrease?

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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 Bank

Corporate 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 issuers balance sheet.

Bonds are backed by a covered

pool of assets:

Mortgages Loans

Public Sector Loans

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Securitised Debt & Structured Credit

Senior/ junior securitised debtPredominantly 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 an

underlying 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/operators

Examples of Types of Collateral Offered


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Liquidity and Collateral Considerations

Addition considerations Collateral Requirements

Pension funds generally hold a reserve of liquid assets to service any potential collateral calls arising from their

existing 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 trade

will have on this reserve, as the basis of such trades involves pension funds foregoing access to some of their liquid

assets a for pre-determined time.

0

100

200

300

400

500

600

700

Collateral Requirements Avaliable Collateral

GBPMillions

Collateral Requirements

Conventional Gilts Inex-l inked Gilts + Asset Swaps 1 Year VaR of Swaps 1 Year of VaR of Gilts

0

100

200

300

400

500

600

700

Collateral Requirements Avaliable Collateral

GBPMillions

Collateral Requirements

Conventional Gilts Inex-l inked Gilts + Asset Swaps 1 Year VaR of Swaps 1 Year of VaR of Gilts


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Disclaimer For professional investors only.Not suitable for private customers.

The information herein wasobtained from various sources. We do not guarantee every aspect of itsaccuracy. 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 actualtrades. Anyhistorical exchange rates, interest rates or other referencerates or priceswhichappear above arenot 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.

Anyreference to thetermsof executedtransactions shouldbe treated as preliminary andsubjectto further duediligence .

Redington Ltdare investment consultants regulated by the Financial Services Authority.We do notadvise on all implications of thetransactions 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 anyothernature),should be treated as illustrative only andnot relied upon as accurate.

Redington Limited 2011. Allrights reserved.No reproduction, copy, transmission or translation in whole or in part of this presentationmay be made without permission. Application for permission should

be made to Redington Limited atthe address below.

Redington Limited (reg no 6660006) isregistered in England andWales. Registered office:13-15Mallow StreetLondon EC1Y 8RD

THE DESTINATION FOR ASSET & LIABILITY MANAGEMENT

ContactsDisclaimer

Direct Line: +44 (0) 20 3326 7134

Telephone: +44 (0) 20 7250 3331

Redington

13-15 Mallow Street

London EC1Y 8RD

Karen Heaven

Vice President | Investment Consulting

[email protected]

www.redington.co.uk

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