Revitalising the markets

The failure of the UK Debt Management Office (DMO) to sell all its 4.25% 2049 gilts in an auction on March 25, the first time this has happened since 2002, highlighted the parlous situation faced by many governments seeking to revitalise their financial markets. The focus on economic stimulus has seen the UK Treasury push through huge debt issuance packages in recent months, but meeting the supply with adequate demand could prove a tough task.

While government bonds are generally considered a safe haven in these troubled times, the future sale of sovereign issues is by no means being taken for granted with such huge supply entering the market. Recessionary pressures have meant that the UK is borrowing more than ever before, and the DMO was assigned the none-too-easy task of raising £146.4 billion by the end of the 2008/09 financial year, with a whopping £220 billion scheduled for 2009/10. This sum is easily the largest on record, dwarfing the £62.5 billion raised in 2006/07 and the £58.4 billion in 2007/08.

Robert Stheeman, the DMO's chief executive, acknowledges the size of the task, and accepts the possibility of seeing further failed auctions in the future. But while Stheeman is fully aware of the negative implications of the recent failed auction, he remains confident about the draw of UK debt, which, after all, has not defaulted in more than 300 years.

Risk: What effect has the financial crisis had on the DMO's issuance policy?

Robert Stheeman: The biggest impact of the financial crisis has been on our overall borrowing programme. At the time of the budget for last year, we announced £80 billion would be raised for the 2008/09 financial year. That number has been revised twice - once in October when we added £30 billion and once last November when we were mandated to raise a further £36 billion. The overall figure of £146.4 billion was an issuance record for the DMO. If you revise something up by that amount, it clearly influences how you are going to do it. For example, historically we have been skewed towards long-term issuance, but the size of the funding requirements has meant we have been forced to tap into the demand for short-term debt. This is one particular aspect we have changed to meet the demands of the current economic climate.

Risk: How did the DMO look to address the problems in the financial markets when the crisis started to take hold in 2007?

RS: The DMO's strategy focuses on delivering the annual financing and cash management remits we receive from the Treasury. Our debt management objective is to minimise the long-term cost of finance, taking risk into account. Clearly, the market environment has been increasingly challenging, but we have successfully delivered our remits, raising record amounts of cash. Our approach throughout is to work very closely with our market counterparties, in particular the gilt-edged market-makers - or primary dealers - to help design and implement an issuance programme that is well received and, as far as possible, in line with market appetite.

Risk: How significant is the recent failed auction? In the past, you have said a one-off failed auction would not be too damaging. Do you still think so?

RS: I have been quoted as saying you can't exclude the possibility of a failed auction. And this is quite true: no-one would say you could discount this possibility. But I don't see one failed auction as a huge issue. It would be wrong to focus on one specific event. You need to see this in context. Uncovered auctions reflect the market supply and demand dynamics on a particular day. And we still managed to raise around £1.5 billion of 40-year bonds at historically low levels of 4.51%. This is very good value for the taxpayer.

Risk: Why did the auction failure occur and what are the chances of this happening again? Are you worried?

RS: Market volatility is the biggest single factor behind this. You had seen extraordinary price movements in the days prior to this, which definitely made things more difficult. At the same time, there could have been imminent end-of-year balance-sheet restrictions that prevented some investors from coming into the market. I would also say the 40-year end of the curve is a risky area for us to issue into. It is not the deepest or most liquid part of the market, and it doesn't surprise me there was a little trouble in placing the debt into the market. I'm not saying this will or won't happen again - you could well see this repeated. But if you choose a market auction as the primary way of distributing debt at times when markets are volatile and risk appetite is low, there will always be the chance of this happening.

It is a risk we run every time we have an auction. But as long as we have reasonable processes in place, I am satisfied with how we go about it. Indeed, I remain very confident about meeting our issuance target. The UK remains the benchmark borrower in its domestic currency, and gilts remain the preferred risk-free asset for buyers.

Risk: But there are huge amounts of gilts to be issued, which could deter some participants coming in. And you had seen some weakness in demand in one or two of the auctions prior to the 2049 sale.

RS: I don't think the future supply should be taken as a direct cause of this event. The last time we saw an uncovered auction, in September 2002, the borrowing requirements were a fraction of what they are now. In that year, we ran 14 auctions. In 2008/09, we did around 60. So you can't make a direct link between supply and our ability to successfully auction all the debt in the period.

We are confident there will be buyers out there. We can look back on the past few months with satisfaction, bearing in mind the vast amount of issuance we have already successfully carried out. I think the auction process to date has gone very smoothly. This is a testament to the strength of the market, showing that we have a deep and liquid bond market in the UK. And the primary market-making system - the gilt-edged market-makers - has shown itself to be exceptionally capable of fulfilling its role. I feel this will continue to be the case.

Risk: Does the shift in the banking sector over the past 12 months exacerbate the risk of future failed auctions?

RS: While we have lost two market-makers - namely ABN Amro and Lehman Brothers - we still have 16 others making markets. Turnover is high and liquidity is strong. While banking is under pressure, this doesn't translate into a lack of desire to get involved in the government bond markets. Indeed, the risk appetite in the market and the demand for buying debt has not been impaired.

Risk: Is it beneficial to have the issuance target set out so far in advance?

RS: This is an approach we have adopted since the 1995 debt management review. We believe a predictable and transparent issuance regime provides market participants with a welcome degree of certainty about our gilt issuance plans against which to plan their investment strategies. Markets don't like uncertainty and will charge a premium for it. So, all other things being equal, our approach should help reduce our cost of financing.

Risk: The governor of the Bank of England, Mervyn King, has warned against more government borrowing to fund further stimulus packages. There is also the view the government has gone all-in with its current financial policy - the bank bail-outs, interest rate cuts and quantitative easing. What views do you have on this?

RS: This wouldn't have any bearing on our debt management policy. We wouldn't alter the decision-making process as a result of what the Bank of England says on quantitative easing. Quantitative easing is part of the bank's role in implementing monetary policy. It has statutory independence in carrying out this role. We don't give any input to the Treasury over the issuance target. There is a divide between the DMO's policy and monetary policy. If you believe in the divide, you have to accept the consequences of it.

Risk: How big a threat is inflation in your issuance considerations?

RS: Clearly, in the immediate future, the inflationary situation is benign - even deflationary. It is likely, however, that as the economy recovers, inflationary pressures will begin to reassert themselves and, in that event, it will be for the Bank of England to implement monetary policy accordingly.

Index-linked gilts, and especially longer-dated maturities, are highly sought after by the UK pension and insurance industries seeking assets to match their liabilities. As a rule of thumb, we aim to have around one quarter of the debt portfolio in real - as opposed to nominal - instruments. Index-linked gilts minimise the inflation risk to investors by fixing the real return at the point of issue, and this should be of benefit to us as an issuer if investors are prepared to pay a premium for this insurance.

Risk: Do you feel quantitative easing is a long-term solution, and how concerned are you about the risks - again, inflation?

RS: Quantitative easing has not had an effect on us. We are not trying to second-guess what the Bank of England is doing in terms of its buyback policy. But clearly, it has had an impact on the market. For example, you have seen a sharp decline in yields in that area, which the bank is targeting.

Normally in an established market, you have one established issuer - in this case, the DMO - and pockets of demand. But suddenly, with quantitative easing, the market has to adjust to the appearance of a new purchaser. The fact is it takes time to make this adjustment and it doesn't surprise me you have seen swings in the market.

Risk: The DMO has already issued debt at historically low yields earlier this year. Will this continue? And will investors continue to come in at these levels?

RS: Yields ultimately tell you what price evolution there has been already. If yields are declining, it means people are paying ever higher prices for the debt on offer. It could be that some investors may not want to come in at the current levels, but generally demand remains high. And I wouldn't read too much into individual auctions. For example, our long-term debt auction (2039 gilt) at the beginning of March had around 1.5 times the number of bids to the amount on offer, which could be seen as relatively low. But the auction we had the week after, for inflation-linked bonds (2032 maturity), had the highest cover for over two years, at 2.62 times the supply.

Risk: The turmoil in the credit markets has led to increased pressure on European sovereign debt. There has even been talk about the potential of a major sovereign defaulting. Has this affected the way investors are assessing the strength of UK issuance?

RS: I don't think the issue of the sovereign debt rating will lead to nervousness. Irrespective of this, as a sovereign borrower, we have the good fortune of being able to issue into a well-developed, mature government bond market. The rating agencies' actions have a greater effect on price than anything else. I don't see any signs at all that investors are not prepared to invest in UK government debt.

We have risen successfully to the challenge of meeting a sharply higher financing requirement in 2008/09 and the provisional remit for 2009/10 published in March shows a very similar amount next year (£147.9 billion) (this was increased to £220 billion in the budget, announced on April 23). The gilt market has proved to be resilient to the challenges of the past 18 months. I am confident this will continue.

Risk: The DMO has sought to undertake some changes to the gilt distribution methods. What are the main changes you are exploring? And is execution risk a big factor in your issuance considerations?

RS: Our consultation reflected a wish to explore with all gilt market participants whether there is a need to support the auction process with the use of supplementary gilt distribution methods, and, if so, what methods should be introduced. A key objective is to better facilitate an increased outright supply of long-dated and index-linked gilts in the context of both high forecast financing requirements in the next few years and the government's medium-term strategy to skew issuance towards long-dated maturities, in the event that strong demand for long-dated and index-linked gilts continues to influence the shape of the nominal and real yield curves.

We have announced that mini-tenders of gilts will continue to be used in 2009/10, in broadly the same way as now, with two scheduled to be held in April and May. We have also said we see merit in the use of syndication in 2009/10, alongside the auction programme, to issue larger volumes of long-dated conventional and index-linked gilts per operation than we judge would be possible via auctions alone. Syndication as a method for issuing gilts already exists as an option in the financing remit, but has been dormant since September 2005, when we launched the new 2055 maturity index-linked gilt in this way.

Risk: Will you look more closely at issuing through syndication on the back of the recent failed auction?

RS: We won't be looking at syndication as an option to pursue purely on the back of this failed auction. This event won't make me say we need to change the auction process. Indeed, we would be acting very hastily if we felt this event by itself necessitated changing the auction process.

Risk: The UK's sovereign debt credit default swap spreads have widened significantly since the beginning of the year. In your opinion, is the CDS market a good barometer of the strength of the overall sovereign debt markets?

RS: I think they may play a more important indicator role in distinguishing between a number of sovereign issuers that are issuing debt in the same currency. For the UK government, however, which is the sole supplier of AAA rated debt in sterling, I think they are less significant. In practical terms, I would point to the fact that the UK government has not defaulted on a coupon or capital payment on its debt since 1694.