The UK Debt Management Office (DMO), as this report went to press, was set for what was shaping up to be another spectacular syndication. Having already extended its conventional Gilt curve with a blowout £5bn 3.5% 2068 bond, the DMO is set to extend its linker curve to the same maturity point. But away from the UK’s headline grabbing syndications, there are other reasons to be positive about the market.
At roughly the halfway point through the UK’s financial year, government borrowing is just under 40% of the total fiscal year forecast of £120bn, excluding QE cashflows, according to research by Sam Hill, RBC Capital Markets’ UK fixed income strategist.
That compares well to the previous three years when the UK has been over 40% at the same stage, he says. And that bodes well for the prospect of the government not having to borrow its full forecast amount by year-end, especially given the recent spate of better economic data.
The IMF in June revised upwards its growth forecast for the UK from 0.7% to 0.9%, while second quarter growth was revised up by the Office for National Statistics from 0.6% to 0.7%.
There have also been improvements in employment numbers, construction starts, manufacturing orders, retail sales and export numbers.
But there has also been a rise in yields, as there has been globally, since the beginning of May when investors started to react to the potential tapering of quantitative easing in the US. The 10 year Gilt has risen from yielding 1.62% to around 2.90% in that time.
And so it is hardly any surprise that international investors have added to their Gilt holdings. International participation in the fabled Gilt syndications typically runs at around 10%. But the DMO most often runs long-dated syndications, which international investors — often central banks — do not want to buy. Instead they buy maturities of 10 years and below and so it is the secondary market where the effect can be seen.
“When looking at the statistics that we’ve published, it really is also worth looking at the nominal figures,” says Robert Stheeman, chief executive of the DMO. “At the end of Q1 2013, 31.2% of the overall Gilt portfolio was held overseas, versus 30.7% a year previously. That doesn’t sound like a big change, but when you look at numbers such as, it was £380bn at the end of Q1 2012 versus £432bn at the end of Q1 2013 — that is a pretty sizeable increase.”
Although the improved UK data hardly smacks of a booming macroeconomic recovery, the UK has enjoyed a sustained safe haven bid throughout the era of financial crisis. But Stheeman thinks there is more than that behind the increase in international interest.
“It is in the nature of any safe haven bid that it can and probably will be unwound, because at one point the assessments of the respective strength of sovereign issuers will change,” he says.
“But I would like to think that the Gilt market will continue to benefit from the participation of major overseas investors, because people have a positive view on the Gilt market or the currency.”
Domestically, there has been little change to the investor base, says Christophe Coutte, head of rates at Lloyds Bank. But there have been shifts in the levels of demand from domestic players, prompted by greater financial regulation.
“Some of our LDI buyers — pension funds and life insurers — are buying bigger sizes than before,” he says. “We’re also seeing more buying from bank treasury desks. The increase in the Gilt issuance programme has been met with growing appetite from investors looking to meet their new capital requirements.”
Curve extension
Whether the macroeconomic scene continues to improve in the UK or not however, and what affect that might have on Gilt supply, there are still notable supply events this fiscal year through the DMO’s syndication programme.
The 2068 inflation linker is just such a bond and the choice of deal exemplifies the uncommon amount of work that the DMO puts into bringing a deal its investors want. After all, when there are just a handful of domestic liability-driven investment (LDI) buyers that dominate your order books at the riskiest end of the curve, it pays to listen when you have a large borrowing requirement.
The DMO first consults with its primary dealers — called Gilt Edged Market Makers (GEMMs), and key investors. In the case of the 2068 linker and the conventional 2068 Gilt that preceded it, there was a clear investor interest to extend the UK’s curve.
“In choosing these maturities we don’t have any fixed approach,” says Stheeman. “We’ve got an open mind. Once we’ve set the parameters, we try and seek feedback from the market and try and do what we think is best for the programme and best for the market, and those two usually go hand-in-hand.”
The desire on the part of investors — pension funds and life insurers — is to have a hedging instrument to buy to cover their long-dated liabilities. Rarely, unlike other markets, do investors extend along the curve to pick up extra yield.
“In the case of our ultra-long or super-long issuance, it is very much driven by the specific need of the UK pension fund industry to match assets and liabilities, rather than just a vague sense of desiring yield pick-up,” says Stheeman. “Not that yield pick-up isn’t occasionally present, but the yield curve, from 30 years upwards is very flat, if not slightly inverted, and the further along it you go, it’s not obvious that you’re going to see much in the way of extra yield pick-up.”
For the DMO the syndication programme, expected to raise £21bn this fiscal year, offers greater quality and quantity of dialogue with investors than it could achieve through auctions alone.
“The information that we gather, as a result of the whole process, is vastly in excess of what we would gather just through the auction process alone,” says Stheeman. “Our knowledge of the market over the last four years now as a result of the syndication programme has increased hugely. The quantity and quality of the dialogue with the investor base has increased. That’s ultimately to the benefit of the Treasury and to the Exchequer as well.”
FRN idea sinks
Aside from curve extending conventional and inflation-linked Gilts, however, investors can expect precious little innovation in terms of new products from the DMO, and investors should not expect one of this year’s big investment trends — floating rate notes — any time soon.
Although the DMO has monitored the trend in the dollar market, it has structural reasons not to want to offer its own product. “The driver towards the USA’s issuance of floating rate notes is fundamentally to do with the average maturity of their debt, which is a little over five years,” says Stheeman. “Ours is a little under 15 years so the impetus is a different one here.
“Our job is to minimise the cost of borrowing rather than fix the market’s structural problems. That doesn’t mean that we don’t have a potential interest in it, but it will be interesting to see if the sort of scenario that you’ve just painted leads to specific demand for collateral, which would potentially translate into better financing costs for us at the other end.”
It is an issue that GEMMs have wrangled with recently in determining what advice to give the DMO. “We looked at whether there was a credible story for floating rate Gilts — who would they appeal to?” says Coutte at Lloyds Bank. “It could be economically attractive for bank treasuries currently buying fixed rate Gilts and asset swapping them to directly buy floating rate Gilts. It could also be of interest to retail investors who want to enjoy the potential back up in yields.We tried to assess the potential volume and it would only have been a small portion of Gilt issuance but it may be of greater interest when we are in a rate hiking environment.”
“The vast majority of FRN buyers are able to buy fixed rate notes on an asset swapped basis,” says Dan Shane, head of SSA syndicate at Morgan Stanley. “So while we have seen an increasing trend in FRN issuance, a large majority of that is simply a shift of buyers who would otherwise have bought fixed rate securities and asset swapped them, saving themselves paying the bid/offer in terms of executing the derivative.
“There are very few accounts that I can think of that have demand for floating rate instruments that are not in a position to buy an asset swapped fixed rate bond.”
Supply side
There are several factors that could affect Gilt supply but the DMO aims to provide as consistent as possible an approach, even in the face of potential windfall events such as the sale of the government’s stake in Lloyds Bank. “Revisions in our remit are not dependent on individual transactions such as the possible sale of Lloyds,” says Stheeman. “We try and accommodate any sudden intra-year changes to the financing requirements through our cash management operations.
“We place a lot of emphasis on trying to make sure that the Gilt programme, within reason, is protected unless there’s a very, very significant movement in government finances, which tend to be announced at fixed times — one being the Budget, the other being the Autumn Statement.”