Redington13-15 Mallow StreetLondon EC1Y 8RD

T. 020 7250 3331www.redington.co.uk

Sweating your AssetsKaren Heaven– Redington

8 June 2011

• 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

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Introduction

Gilt Repo and Gilt TRS

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

Real 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 as Swap Yield minus Gilt Yield

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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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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 RatesWhat has happened in the market?

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Nominal swaps have historically yielded higher than Gilts

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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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 risky assets

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

•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 RepoHedging Nominal Rates

Gilt Repurchase (“Repo”) Agreement

Pension SchemeCounterparty e.g. Investment bank

Receives Cash (C)

Sells Gilts1

Pension SchemeCounterparty e.g. Investment bank

Buys Gilts

Pays cash (C + repo interest amount)

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What is a Gilt RepoHedging Nominal Rates

Gilt Repurchase (“Repo”) Agreement

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• Gilt repos are transacted under a “Global Master Repurchase Agreement” (GMRA), the standardised repo

documentation, 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 LIBOR

Overnight 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 very

secure 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 England

prioritised ensuring that it continued to function during the

worst days of the financial crisis

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 a45.8bp on the variable leg when compared to swaps as at 6 June 2011.

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Alternative ways Gilt financed by Repos

Total Return Swaps

Hedging 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 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

Hedging Nominal Rates

• 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 cash requirement

Counterparty balance sheet charge

Rollover Risk

Alternative to repo

Gilt yields higher than swaps

Unfunded

Advantages/Disadvantage of TRS

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

buy the gilt and finance it through the repo

market, 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

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 TotalReturn Swap

(e.g. 2 yr)

Pay(2): 6m LIBOR[+/-X]bps

Rec: Gilt Total Return

=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 TRS

Liquidity • 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 England’s money market operations

• Long maturities may not trade in a crisis

• Pricing at rollover dependent on counterparty’s capacity and balance sheet charges (TRS consumes the counterparty’s 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 TRS

Transparency • 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 and expense

• 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

Collateral Upgrade Trades

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:

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 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).

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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 a pension 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 bank’s option?

• What measures can be implemented that help ensure that the value of the collateral held doesn’t decrease?

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Sovereign Bonds

•Senior unsecured debt

•Varying levels of credit ratings depending on issuing government

• Includes quasi-governmental bonds such as supranational bonds – issued by institutions such as the European Investment Bank and the World Bank

Corporate Bonds

•Senior unsecured debt

•Varying levels of credit ratings depending on issuing company

•Corporate bonds originate from varying sectors:

•Financials

•Non-financials

•Telecoms & utilities, etc.

Covered Bonds

•Senior secured debt

•Very similar to asset backed securities except that the assets remain on issuer’s 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 debt

•Predominantly Asset Backed Securities:

•Consumer Credit – backed by underlying pool of consumer receivables (i.e. auto loans, credit card payments etc...)

•Commercial Mortgage – backed by underlying 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 loans used by companies to buy items such as planes.

•Education Loans – consists of loans to Higher Education institutions.

•Private Finance Initiative (PFI) – private financing to Government procurement and infrastructure projects.

•Social Housing Loans – loans to social housing developers/operators

Examples of Types of Collateral Offered

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.

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Collateral Requirements Avaliable Collateral

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Collateral Requirements

Conventional Gilts Inex-linked Gilts + Asset Swaps 1 Year VaR of Swaps 1 Year of VaR of Gilts

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Collateral Requirements Avaliable Collateral

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Collateral Requirements

Conventional Gilts Inex-linked 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 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 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

karen.heaven@redington.co.uk

www.redington.co.uk

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