Implications of Divergence between Gilt and Swap Curves

21-23 JUNE 2009

THE GRAND, BRIGHTON

James Walton

Patrick Rowland

Overview

Introduction

Drivers of the swap spread

Recent market conditions

VaR analysis

Implications of current conditions

Introduction What is the risk free rate?

Gilts v swaps

Swap spread

What drives the swap spread?

How can the spread be understood?

Gilt yield

Swap rate

Swap spread

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.

Factors Impact 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 maturity Spread widens

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

Recent Market Conditions

Source: Bloomberg, as at 16 June 2009

Recent Market Conditions UK Nominal Swap Spreads

Le

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an

Co

llap

se

Ce

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Qu

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tita

tive

Ea

sin

g

Incr

ea

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QE

Bu

dg

et 2

00

9

-100

-50

0

50

100

Jul-0

7

Aug-0

7

Sep-0

7

Oct-07

Nov-07

Dec-07

Jan-

08

Feb-0

8

Mar

-08

Apr-0

8

May

-08

Jun-

08

Jul-0

8

Aug-0

8

Sep-0

8

Oct-08

Nov-08

Dec-08

Jan-

09

Feb-0

9

Mar

-09

Apr-0

9

May

-09

Jun-

09

No

min

al S

wa

p S

pre

ad

(b

ps

)

10Y Spread

20Y Spread

30Y Spread

LabelsSource: Bloomberg

Recent Market Conditions

UK Inflation Swap Rate

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Ce

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00

9

Qu

an

tita

tive

Ea

sin

g

1.5

2

2.5

3

3.5

4

4.5

5

Jul-0

7

Aug-0

7

Sep-0

7

Oct-07

Nov-07

Dec-07

Jan-

08

Feb-0

8

Mar

-08

Apr-0

8

May

-08

Jun-

08

Jul-0

8

Aug-0

8

Sep-0

8

Oct-08

Nov-08

Dec-08

Jan-

09

Feb-0

9

Mar

-09

Apr-0

9

May

-09

Jun-

09

Infl

ati

on

Sw

ap

Ra

te (

%)

10Y Inflation

20Y Inflation

30Y Inflation

LabelsSource: Bloomberg

Recent Market Conditions

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)

Recent Market Conditions - LIBOR/SONIA

Source: Bloomberg, 16 June 2009

LIBOR 6 month

LIBOR 3 month

SONIA

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

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

VaR Analysis

Fixed Income Yields 2005 - 2009

2%

3%

4%

5%

6%

7%

8%

9%

10%

Jan-

05

Apr-0

5

Jul-0

5

Oct-05

Jan-

06

Apr-0

6

Jul-0

6

Oct-06

Jan-

07

Apr-0

7

Jul-0

7

Oct-07

Jan-

08

Apr-0

8

Jul-0

8

Oct-08

Jan-

09

Apr-0

9

AA Corp AA less CDS

LIBOR Swaps Sonia Swaps

Gilts

VaR Analysis

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

Upside/Downside VaR Gilt AA AA-CDS Swap

99% 1.12% 1.21% 1.57% 0.96%95% 0.62% 0.59% 0.94% 0.54%5% -0.65% -0.63% -0.89% -0.53%1% -1.11% -1.26% -1.86% -0.86%

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

Mean, Volatility and Correlations on 4 bases:Gilt AA AA-CDS Swap

Mean 0.01% -0.01% -0.01% 0.01%Volatility 0.40% 0.50% 0.60% 0.35%Gilt 1.00 0.63 0.76 0.84AA 1.00 0.81 0.57AA-CDS 1.00 0.65Swap 1.00

Implications of Current Conditions - PensionsLiabilities

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)

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

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

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

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