1. Implications of Divergence between Gilt and Swap Curves 21-23 JUNE 2009 THE GRAND, BRIGHTON James Walton Patrick Rowland

2. Overview  Introduction  Drivers of the swap spread  Recent market conditions  VaR analysis  Implications of current conditions

3. Introduction  What is the risk free rate?  Gilts v swaps Swap spread  What drives the swap spread?  How can the spread be understood? Swap spread

4. Drivers of the swap spread  Significant research in to the swap spread over past 20 years  Key drivers for the swap spread:  Default risk  Liquidity  Supply and demand  Challenge is distinguishing between factors  Decomposing the swap spread Regression of historic data Results depend on period used and method. FactorsImpact on gilt yield Impact on swap rate Default risk Liquidity (convenience yield) Supply and demand LIBOR-spread Slope of yield curve Volatility of interest rates Term to maturitySpread widens

5. Drivers of the swap spread  Example output:  Variously conclude that most of the spread is due to liquidity or credit  No reliable way of decomposing spread using prices of instruments Source: Liu, Longstaff & Mandell Source: Feldhutter & Lando

6. Recent Market Conditions Source: Bloomberg, as at 16 June 2009

7. Recent Market Conditions

9.  Falling spreads since October 2008. Long term spreads have been negative since.  Quantitative easing in March 2009 decreased gilt yields. Index linked gilts not included in QE program so implied inflation squeezed down  Budget announcement re £220 bn of new gilt supply in 2009/10 led to sharp fall in spreads (ie more negative at long durations)

10. Recent Market Conditions - LIBOR/SONIA Source: Bloomberg, 16 June 2009 LIBOR 6 month LIBOR 3 month SONIA

11. Recent Market Conditions - Reasons Demand – why invest in swaps?  Hedging asset for institutions  Swaps can provide leverage, and thus a greater level of hedge than gilts. Capital may be freed up for growth assets.  Swaps provide a more tailored hedge  Solvency II swaps based discount rate

12. Recent Market Conditions - Reasons Supply – why not borrow at swap rates to buy gilts?  Arbitrageurs not functioning, higher internal funding costs, many hedge funds closed. Banks unwilling to expand balance sheet  Transaction costs of arbitrage are high  Institutions relatively slow or unwilling to act on arbitrage opportunities due to advantages of swaps  Subject to calls for cash  Default risk of government (5 year CDS was 160bps in Feb, now 90bps) or payment failure without technical default

13. VaR Analysis

14.  Use yields to calculate daily returns on 10 year maturity bond for Gilt, Corp AA, Corp AA – CDS* and Swaps *Sterling CDS estimated using Euro CDS, assuming sterling CDS explain the same proportion of AA-Gov spread as Euro CDS’s do

15. VaR Analysis  Bonds valued on a AA or AA-CDS basis have been most volatile  Removing CDS rates from AA yields increases correlation with Gilts  10 year swap rates less volatile than Gilts

16. Implications of Current Conditions - Pensions Liabilities  Limited use of direct swaps curve valuations Assets  Switch cash backed swaps to Gilts/Corporates.  Hedging solutions mix gilts, credit, swaps where most attractive or forced to do so along curve.  Asset swaps (swap Gilt for a LIBOR plus return). Could support interest rate swaps or TRS  Repos (unfunded exposure to ILG or Gilts at preferable rates to swaps)

17. Implications of Current Conditions - Pensions Issues to consider:  Level of leverage required  Degree of cashflow matching required  Transaction costs and liquidity  View of future swap spread movements

18. Implications of Current Conditions - Life  Rebalancing of swap and swaption portfolios  Life companies have been more active in hedging using swaps. Given the spread is this still appropriate?  Switching to gilts may not be attractive if need to unwind when position is reversed  Layering of swaps to lock in spread  Uncertainty over reference rates  Current focus is on swaps

19. Summary  Difficult to analytically decompose swap spread in to components  Long term swap spreads are negative. Some drivers for this are arguably short term (ie liquidity and high cost of capital)… but others will remain (demand for swap hedging over gilts)  Recent conditions give rise to additional issues when valuing liabilities and setting investment strategy

20. Yield curves working party  Thanks to all the members of the yield curve working party for their contributions:  Joseph Collins – Lucida  Con Keating – Brighton Rock  Adrian Lawrence – BGI  Patrick Rowland – KPMG  Shalin Shah – Royal London  Andrew Smith – Deloitte  James Walton – Aon