Hedging bond portfolios CLS Winter Conference 2014

Hedging bond portfolios

CLS Winter Conference 2014

Historical yields

2

Measures taken to mitigate duration risk

3

Hedges utilising simple derivative strategies

4

Short gilts

•6 year bank issued note

•1, 2 or 3 times short 7-10 year gilts at maturity

•Rolling of gilts to maintain duration

•Additional floating coupon of 3 month libor +….

Short

1 X 2 X 3 X

3 M GBP Libor + 1.00% 2.25% 2.50%

Structure implicitly floored if you assume rates can’t go below zero

Assuming a gradual increase in yields over the next six years

Year 0 0.5 1 2 3 4 5 6Yield 2.60% 3.00% 3.50% 4.00% 4.50% 5.00% 5.25% 6.50%3 month libor 0.52% 0.60% 0.70% 0.81% 0.91% 1.01% 1.06% 1.31%Long Bond Portfolio 100.00% 98.15% 95.83% 95.57% 95.80% 96.50% 99.55% 95.48%Short Bond Mark to Market 100.00% 103.61% 107.96% 110.20% 111.81% 112.81% 110.37% 118.75%

Year 0 0.5 1 2 3 4 5 6Yield 2.60% 2.00% 1.50% 1.00% 0.50% 0.00% 0.00% 0.00%3 month libor 0.52% 0.40% 0.30% 0.20% 0.10% 0.00% 0.00% 0.00%Long Bond Portfolio 100.00% 106.07% 111.38% 117.39% 123.12% 128.47% 128.47% 128.47%Short Bond Mark to Market 100.00% 91.67% 84.45% 76.79% 69.45% 62.58% 63.68% 64.78%

Fixed rate bonds into floating

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Collateralised Note

Platform

Collateralised Note

Platform

Bank Counterparty

Investor

1. 3 Month Libor + /-

2. Principal at maturity

Cash

CollateralCollateral

Day 1

1.Investor sells existing portfolio of fixed coupon bonds. 2.Investor buys a floating rate note with the cash proceeds.

During the life

1.Cash flows arising from the Collateral are passed to the Bank Counterparty. 2.In return, the Bank Counterparty will pay a libor linked coupon.

At maturity

1.Investor receives 100 less any default amounts on collateral

Fixed Coupons

1. 3 Month Libor + /-

Investor effectively creating floating rate notes, whilst maintaining the credit profile of their original portfolio.

Fixed rate bonds into floating

6

Collateral Indicative Coupon Level

RBS 6.5 21 3m GBP Libor + [3.07%]

VOD 8.125 18 3m GBP Libor + [0.59%]

CPUK 7.239 24 3m GBP Libor + [2.34%]

LLOYDS 10.75 21 3m GBP Libor + [7.48%]

UKT 1.75 19 3m GBP Libor +


7

Are we at maturity of the

option?

Yes

No

Are current rates above the option strike level?

Yes

No

Coupon Paid

No CouponOption traded in

secondary at MTM

Strike (10 year swap rates)

Option expiry (years) 3% 4% 5% 6%

3 2.75% 5.00% 12.50% N/A

4 2.50% 4.25% 9.25% 21.00%

5 2.50% 4.00% 7.50% 16.50%

6 2.50% 3.80% 7.00% 14.50%

2.5 pence premium buys you

Digital Options


8

Time to maturity (years)

4 3 2 1 0

Rates Shift 0.00% 0.25% 0.50% 0.50% 0.50%

MTM 1.60% 1.30% 0.50% 0.00% 0.00%

Rates Shift 0.50% 1.00% 2.00% 3.00% 3.50%

MTM 2.80% 3.35% 5.35% 7.75% 16.50%

Rates Shift 1.00% 2.00% 3.00% 3.00% 3.00%

MTM 4.90% 9.45% 13.40% 7.75% 0.00%

Digital Option

•5 years

•GBP

•Strike 6%

•Coupon 16.5%

•2.5% Premium


9

Payer Swaptions

•Provides the holder with the right to enter into a fixed versus float swap

Party BParty A

Pay a fixed rate

Receive a float rate

• At inception the value of the swap is zero,

since PV of float leg equal to that of fixed leg.

• If rates go up, the mark-to-market of the swap

will go in favour of Party A and vice versa.

Fixed versus float swaps


10

Are we at maturity of the

option?

Yes

No

Are current rates above the option strike level?

Yes

No

Swap value

No PaymentOption traded in

secondary at MTM

Payer Swaptions

•6 month duration

•Option to enter into 10 year fixed versus float swap

•Cash settled, based upon market value of the fixed v float swap at expiry of the option


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Payer Swaptions

•6 month duration

•Strike ATMF + 100bps

Swap Expiry (years)

Option expiry (years) 3 5 10

3 15bps 20bps 19bps

4 21bps 25bps 23bps

5 23bps 30bps 27bps

6 27bps 37bps 35bps

12 57bps 77bps 82bps

24 105bps 135bps 167bps


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Time to maturity (months)

6 5 4 3 2 1

Rates Shift 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

MTM 0.28% 0.20% 0.10% 0.08% 0.04% 0.00%

Rates Shift 0.00% 0.25% 0.250% 0.50% 0.50% 0.50%

MTM 0.28% 0.33% 0.22% 0.24% 0.12% .02%

Rates Shift 0.00% 0.25% 0.50% 0.50% 1.00% 1.00%

MTM 0.28% 0.33% 0.41% 0.24% 0.82% 0.46%

Digital Option

•6 months

•GBP

•7th July 14 – 7th July 24 fixed v float

•35bps premium

Alternative ways to play rates

13

Equity linked digital

•6 years

•GBP

•S&P / FTSE

•EKI Put 60%

•Digital Barrier 60%

•Coupon Payment Semi-annual

•Digital Coupon

Both underlyings at or above Digital Barrier

226% * GBP 6-month Libor p.a.

Equity linked reverse convertible

•10 years

•GBP

•S&P / FTSE

•EKI Put 60%

•Payment at maturity

Both underlyings at or above put barrier

100% + Max (5.80%; 3M Libor +1.30%)

Worst of underlying below put barrier

100% + Max (5.80%; 3M Libor +1.30%)

minus worst underlying performance

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley Lakeman Securities makes no

guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any

person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this document constitute the

present judgment of Catley Lakeman Securities, which is subject to change without notice. This document is neither an offer to sell, purchase or subscribe for any

investment nor a solicitation of such an offer. This document is intended for the use of institutional and professional customers and is not intended for the use of

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Number: OC336585, FSA Reference: 484826

DISCLAIMER

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Hedging bond portfolios CLS Winter Conference 2014