Risk and Investment Conference Brighton, June

Transcription

1 Risk and Investment Conference 03 Brighton, 7 9 June 0 June 03

2 Acquiring fixed income assets on a forward basis Dick Rae, HSBC and Neil Snyman, Aviva Investors 8 June 0

3 Structure of Presentation Introduction to forward Pricing and Practicalities Examples Q & A PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 3

4 Introduction Insurers and pension funds hold assets to collateralise their liabilities with capital held additionally as provision against potential losses Asset yields relative to liability valuation rates (asset spreads) should be an important consideration This needs to be balanced against their risk profile (ie. required capital treatment) In this presentation we consider the term structure of asset spreads and specifically decomposing into forward spreads PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 4

5 Introduction What do we mean by forwards? 3.0%.5%.0%.5%.0% 0.5% 0.0% yr Spot Forward yr -0.5% PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 5

6 We consider different liability structures Three sets of liabilities Insurance funds with exogenous valuation basis typically Libor based and Risk Based Capital requirement Annuity funds which is a special case within Insurance with valuation basis dependent on underlying assets held and Risk Based Capital requirement Pension funds which have less prescribed valuation basis and no Risk Based Capital requirement which allows a more flexible approach PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 6

7 Considering forward yields and spreads 4.0% 0.3% 3.5% 3.0%.5% 0.% 0.%.0%.5%.0% 0.5% Swap Rates Gilt Yields 0.0% -0.% -0.% Gilt Spreads over Swaps 0.0% % We invest in fixed income assets for their spread and want this to be positive to avoid liabilities growing at a faster rate than the assets collateralising those liabilities However capital requirement for credit spread risk is an almost linear function of duration This pushes you into short maturities PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 7

8 Considering forward yields and spreads 4.5% 0.5% 4.0% 0.4% 3.5% 0.3% 3.0% 0.%.5% 0.%.0%.5%.0% 0.5% 0.0% Spot Yields Forward Yields % -0.% -0.% -0.3% -0.4% Fwd Gilt Spreads over Swaps Spot Gilt Spread over Swaps Credit spread curve is steep in the front and then flatten out Short dated credit spreads are negative Most capital efficient solution would be to have positive spread while still having short credit duration We want to have exposure to the positive forward spreads PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 8

9 Considering forward yields and spreads Historic Gilt Spread Widening Historic Credit Spread Widening AA A BBB Gilts years 5-0 years 0-5 years 5-5 years 5+ years years 3-5 years 5-7 years 7-0 years 0+ years Gilt spread volatility has been flat along the term structure Corporate bond spread volatility has been higher at the short end (where spreads are lowest) So even if forward spreads were equal at all maturities it would still be more efficient to take forward bond exposure for the reduction in credit spread risk (and thus the required capital to allocate to it) PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 9

10 Forward bonds indicative levels Forward settlement date Underlying Bond Spot Y 3Y 4Y 5Y Forward GBP rates Forward OAT rates UKT % 3.66% 3.80% 3.9% 4.00% Swap rate 3.6% 3.40% 3.5% 3.6% 3.69% Pick-up 0.% 0.6% 0.8% 0.30% 0.30% OAT % 3.46% 3.6% 3.74% 3.83% Swap rate.4%.6%.7%.80%.86% Pick-up 0.68% 0.84% 0.90% 0.95% 0.97% Forward NL rates NL37.50%.80%.9% 3.00% 3.06% Swap rate.4%.63%.73%.8%.89% Pick-up 0.0% 0.7% 0.9% 0.8% 0.7% Source: HSBC 4 June 03 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 0

11 Forward Bond definition A forward bond is a forward contract. The investor commits to buy a predetermined financial instrument for a predetermined delivery price at a predetermined future time. Physical ownership Trade date Today Settlement date Physical settlement Underlying bond Final maturity Bond still bought in a credit event PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession 00 The Actuarial Profession

12 Alternative :TRS + an additional swap Physically settled TRS 3 Final maturity Coupon received Purchase price of bond Term repo financing costs paid at maturity Physical delivery of bond Physical 5 settlement Additional swap Reinvested coupons paid at maturity 5 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession

13 Alternative : Repo Buy bond and repo Pay floating under repo Repo roll-over risk Still receive coupons (could swap) 3 Final maturity Bond bought Bond repo d PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 3

14 4/06/00 4//00 4/06/00 4//00 4/06/003 4//003 4/06/004 4//004 4/06/005 4//005 4/06/006 4//006 4/06/007 4//007 4/06/008 4//008 4/06/009 4//009 4/06/00 4//00 4/06/0 4//0 4/06/0 4//0 4/06/03 Alternative : Repo Buy bond and repo Pay floating under repo Repo roll-over risk Still receive coupons (could swap) 0.4% M SONIA BBA 3M Repo rate % June 00 June 03 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 4

15 Forward Bond pricing Forward dirty = Spot dirty + Financing - Re-invested price price cost coupons Bank buys bond 3 Costs and Coupons accumulated Physical settlement Final maturity Bank finances purchase via term repo (bank takes roll-over risk) PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession 00 The Actuarial Profession 5

16 Forward Bond pricing Forward dirty = Spot dirty + Financing - Re-invested price price cost coupons Bank buys bond 3 Costs and Coupons accumulated Physical 5 settlement 4 Final maturity Bank finances purchase via term repo (bank takes roll-over risk) Term repo costs swapped for fixed PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession 00 The Actuarial Profession 6

17 Forward Bond pricing Forward dirty = Spot dirty + Financing - Re-invested price price cost coupons Bank buys bond Final maturity Costs and Coupons accumulated Bank finances purchase via term repo (bank takes roll-over risk) Term repo costs swapped for fixed Bank hedges coupon reinvestment with strip of forward zero coupon SONIA swaps PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession 00 The Actuarial Profession 7

18 Forward Bond pricing Forward dirty = Spot dirty + Financing - Re-invested price price cost coupons 3 6 Physical delivery of bond Final maturity 5 Forward price determined Forward yield of bond = IRR PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession 00 The Actuarial Profession 8

19 Oct- Oct- Oct-3 Oct-4 Oct-5 Oct-6 Oct-7 Oct-8 Oct-9 Oct-0 Oct- Oct- Oct-3 Oct-4 Oct-5 Oct-6 Oct-7 Oct-8 Oct-9 Oct-30 Oct-3 % Notional % of Notional Percentile Counterparty risk management prior to settlement Bank posts collateral Managed through ISDA and CSA Collateral to bank posted 0 Years 5 st 5 th 5 th 50 th 75 th, 95 th 99 th Gives rise to collateral liquidity requirement Covered under ISDA + CSA Physical ownership Trade date Today 00 The Actuarial Profession PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession Settlement date Physical settlement 00 The Actuarial Profession Final maturity 9

20 % Notional % of Notional Oct- Oct- Oct-3 Oct-4 Oct-5 Oct-6 Oct-7 Oct-8 Oct-9 Oct-0 Oct- Oct- Oct-3 Oct-4 Oct-5 Oct-6 Oct-7 Oct-8 Oct-9 Oct-30 Oct-3 % Notional % of Notional Percentile Counterparty risk management prior to settlement Bank posts collateral Collateral to bank st 5 th posted 5 th 50 th 75 th, 95 th 99 th Managed through ISDA and CSA Gives rise to collateral liquidity requirement Shorter term than under a swap (graph below) 0 Years 5 Years The Actuarial Profession -0 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 0

21 Forward Bonds Works for inflation linked bonds too Covered under ISDA + CSA Physical ownership Trade date Today Settlement date Physical settlement Final maturity Inflation linked forward price paid Lock-in real yield The forward real yield is locked BUT the nominal price is not. Price determined on Settlement date, includes realised cumulative inflation from Effective date to Settlement date Fixed nominal forward price paid Lock-in proceeds The forward dirty price is locked BUT the forward real yield is not. Forward real yield determined on Settlement date, based on the realised cumulative inflation from Effective date to Settlement date PUBLIC 00 The - 00 (amend Actuarial The as Actuarial Profession appropriate) Profession 00 The Actuarial Profession

22 Forward Linkers lock-in proceeds pricing Forward dirty = Spot dirty 3 + Financing - Re-invested price price cost coupons Costs and Coupons accumulated Bank buys inflation linked bond Physical settlement Fixed nominal forward price paid Lock-in proceeds The forward dirty price is locked BUT the forward real yield is not. 00 The Actuarial Profession

23 Forward Linkers lock-in proceeds pricing Forward dirty = Spot dirty 3 + Financing - Re-invested price price cost coupons Costs and Coupons accumulated Bank buys inflation linked bond Add step a and swap inflation for fixed at each coupon date Physical settlement Fixed nominal forward price paid Lock-in proceeds The forward dirty price is locked BUT the forward real yield is not. 00 The Actuarial Profession 3

24 Forward Linkers lock-in real yields pricing 6 Final maturity Inflation linked forward price paid Lock-in real yield The forward real yield is locked BUT the nominal price is not. Price determined on Settlement date, includes realised cumulative inflation from Effective date to Settlement date Inflation swap at settlement to swap nominal price for inflation linked price 00 The Actuarial Profession 4

25 Pension example lock-in real yield Pick-up in real yield vs. Swaps Forward settlement date Underlying UK Bond Maturity Spot Y 3Y 4Y 5Y Forward Linker real yields Forward swap real rates Pickup over swaps UKTi 07 //7-0.38% -0.0% 0.03% 0.5% 0.5% UKTi 037 //37-0.% 0.07% 0.5% 0.% 0.7% UKTi 04 //4-0.04% 0.09% 0.5% 0.0% 0.3% //7-0.60% -0.36% -0.6% -0.6% -0.07% // % -0.0% -0.3% -0.08% -0.03% //4-0.3% -0.0% -0.6% -0.% -0.0% //7 0.% 0.6% 0.9% 0.3% 0.3% //37 0.3% 0.7% 0.0% 0.30% 0.3% //4 0.7% 0.30% 0.3% 0.3% 0.33% Source: HSBC 4 June 03 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 5

26 Example : German / French Duration Extension Forward bonds suit continental balance sheets Guarantee reinvestment rate Do not interfere with income statement that drives bonus rate Can be used to embed swaptions to protect against rates up or down Embedding a (receiver) swaption into a forward bond Settlement Forward price On the Settlement Date, Counterparty B takes delivery of the Underlying on a face value equivalent to the Notional Amount and pays the Forward Price Maximum forward price [(Strike Reference rate) x Participation % x DV0] 00 The Actuarial Profession 00 The Actuarial Profession 6

27 Forward bonds indicative levels Forward settlement date Underlying Bond Spot Y 3Y 4Y 5Y Forward GBP rates Forward OAT rates UKT % 3.66% 3.80% 3.9% 4.00% Swap rate 3.6% 3.40% 3.5% 3.6% 3.69% Pick-up 0.% 0.6% 0.8% 0.30% 0.30% OAT % 3.46% 3.6% 3.74% 3.83% Swap rate.4%.6%.7%.80%.86% Pick-up 0.68% 0.84% 0.90% 0.95% 0.97% Forward NL rates NL37.50%.80%.9% 3.00% 3.06% Swap rate.4%.63%.73%.8%.89% Pick-up 0.0% 0.7% 0.9% 0.8% 0.7% Source: HSBC 4 June 03 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 7

28 GBP Example : cash flow matching deferred annuities Liability cash flow -0Yr Gilts 0-0Yr Gilts 0-30Yr Gilts 30-40Yr Gilts 40-50Yr Gilts 0 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 8

29 Example: Annuity fund Annuities are a particular case as they value liabilities at hypothecated asset yields (less default provisions, ) Capital requirement for spread widening although a proportion of this can be offset by higher valuation rate/lower liabilities (RBC still almost linear in duration) For interest rate exposure management, IRS can be replicated with going long gilts for receivers and short gilts for payers This is more efficient in unfunded government bond space as spread curve is upward sloping PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 00 The Actuarial Profession 9

30 Example: Annuity fund Benefit from gilt yields being above swap rate And floating rate being lower than LIBOR PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 30

31 Example: Annuity fund As annuity fund liabilities are not exposed to lapses they only exposed to default losses which justifies their particular valuation treatment This illiquidity of liabilities can be used by considering different issuance by same guarantor, e.g. Network Rail which is guaranteed by UK Govt Spreads over Swaps 40 0 PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession Gilts 50 ILGs UKRAIL 3

32 Example: Annuity fund Network Rail has a real yield of 0% Its IL cashflows can be swapped to 6m L % or 3.30% fixed 08 maturity gilt has a yield of.30% This implies a forward yield of 4.4% or swaps + 90bps Investment Spreads A rated bond Fwd Network Rail PUBLIC 00 The 00 Actuarial The Actuarial Profession Profession 3

33 Questions Comments Expressions of individual views by members of the Institute and Faculty of Actuaries and its staff are encouraged. The views expressed in this presentation are those of the presenter. 33