The UK government revived a centuries-old tradition earlier this year when it convened a meeting of the Commissioners for the Reduction of the National Debt for the first time since 1860. Over dinner at the Treasury, the governor of the Bank of England, Lord Chief Justice and head of the UK’s Debt Management Office discussed Britain’s record £1.5tn debt pile and the then chancellor George Osborne’s proposal that the UK should in future only borrow money under exceptional circumstances.
There are no plans for a second meeting. The turbulence created by Britain’s vote to leave the EU in the intervening months ended Mr Osborne’s role at the Treasury, and put an end to government plans for a budget surplus by 2020. Philip Hammond, the UK’s new chancellor, has signalled that after years of fiscal conservatism the government is poised to begin a new phase of borrowing to mitigate the effects of Brexit.
“There has been an about-turn,” says Philip Brown, head of supranational, sub-sovereign and agency debt capital markets at Citigroup. “And it is the source of intense interest in markets.”
The job of selling British debt — one of the oldest securities in the world whose roots can be traced back to King William III’s desire to fund a war in France — should be relatively straightforward. Domestic and international investors regard the UK as a safe bet. And the Bank of England’s decision to restart a bond-buying programme worth an additional £70bn and cut interest rates to 0.25 per cent — the lowest in its 322-year history — following the referendum led investors to reprice government bonds, known as gilts, at new highs this summer.
At the same time, with central banks in Europe and Japan engaged in monetary easing and the US hesitant over any further rate rise, there has been a rush to bonds that has given gilt investors double-digit total returns in the first eight months of the year, beating the FTSE All-Share index. As rising prices mean lower yields, the rally has provided record-low borrowing costs for the government. In September 2007, the UK’s 10-year borrowing rate was 5 per cent. Now it is less than 1 per cent.
But successfully placing billions of pounds of debt is a complex process in which the UK must compete for investors. “There are some investors that have to buy gilts but others can choose depending on how attractive the price looks,” says Mike Riddell, a fund manager at Aviva. “Every sale is a test of whether the market is working in the way it should.”
Sir Robert Stheeman, the 57-year-old former banker who has run the UK’s DMO for the past 13 years, is fond of using the word “boring” to describe successful operations. “To assume the [market] moves are just one way is naive and short sighted,” he says. “Yields are at extraordinary low levels historically, but there is nothing in the rule book that says they will stay there forever. It generally pays to be circumspect.”
The market is already showing signs of concern about just how long the rally in gilts can last. In recent days, a sell-off has raised yields. Dwindling appetite from international investors, improving economic data and a fiscal policy that increases the supply of gilts all pose potential threats. Previous market meltdowns suggest that with yields so low, the sell-off could be sharp. In a matter of days, rates could jump by whole percentage points — making future government borrowing more expensive.
‘Kindness of strangers’
In the heart of the City of London, employees at the DMO, the 110-strong body responsible for minimising the government’s long-term financing costs, spend their time trying to neutralise any threat to orderly bond sales.
Every month, the UK must sell approximately £11bn of gilts, with the proceeds split evenly between refinancing old debts and funding the day-to-day costs of running the country. The total is double the amount sold a decade ago after the government turned to the debt markets to support the economy in the wake of the financial crisis. That forced policymakers to court a new pool of investors and, alongside the UK’s private-sector borrowing from foreigners, become reliant on what Mark Carney, the Bank of England governor, has called the “kindness of strangers”.
Overseas ownership of gilts jumped from a quarter of the total market to a third as the UK began issuing shorter-dated bonds preferred by foreign banks and treasuries. There is no breakdown of foreign ownership of UK debt but China is thought to be among the biggest buyers.
Crucial to the gilt market and by extension the country’s financial stability, this group is notoriously less “sticky” than domestic investors. In recent years the ratio of gilts owned by overseas investors has slipped back to about 25 per cent and there is concern that the uncertainty surrounding Brexit could weigh on their appetite. In July, for the first time in six months, overseas investors sold more gilts than they bought.
“The DMO is always having to talk to this wide range of investors and ask what they want it to sell,” says Luke Hickmore, senior investment manager at Aberdeen Asset Management. “It is an ongoing and tricky conversation.”
Demand from overseas investors is “fine but nothing to get excited about”, according to a gilt trader at one European bank, adding that the drop in sterling had a huge impact on returns for overseas investors. Since interest on a bond is fixed at issue, prices rise as yields fall and record-low gilt yields have provided domestic investors with a 13 per cent return so far this year. But a US investor without a currency hedge who converted that return into dollars would receive less than 2 per cent. An investor in euros would see a loss of 2 per cent.
“In some ways low borrowing rates sound fantastic for a country,” says Mr Brown at Citigroup. “But the UK is gearing up to increase its deficit — which means it will be hoping to increase the amount of gilts it sells. To do that, it has to rely on investors willing to buy very low-yielding debt, including foreign investors who are watching the value of sterling closely and who might be more cautious about buying if the currency continues to weaken.”
‘Grit in the machine’
At the start of the year, the UK’s gilt market and the DMO faced a rare problem. For the first time since the eurozone crisis, officials announced that a government bond sale ran the risk of failing after a debt issue generated investor bids equivalent to 1.07 times the amount sold — barely enough to cover the auction.
To keep its debt funded, the UK needs a smoothly functioning market and the constant participation of investors. A single failed gilt auction would not be catastrophic to government funding plans but it would mean there was “grit in the machine”, says Sir Robert.
Some blamed the banks that make a market in gilts — buying them at auction before selling them on to investors — for the tightness of the sale. The problem is that global government debt is ballooning at the same time that banks are reducing their balance sheets.
For all the surprise, the warning signs had been visible for some time. A government committee had attempted to raise its concerns with the BoE three months earlier, warning about declining liquidity in bond markets and the threat posed to gilt market operations.
Andrew Tyrie, chair of the UK parliament’s treasury select committee, said tougher financial regulation designed to make the industry safer in the wake of the financial crisis had made it more expensive for banks to participate in gilt auctions by forcing them to hold larger sums of capital against the bonds they buy. Soon after the subject was raised, the committee’s fears were realised when Société Générale resigned as a gilt-edged market-maker in January.
The role had been widely regarded as prestigious, lucrative and instrumental in building relationships with government. And if the French bank’s snub had been a one-off, it might have passed without comment, but a few months earlier Swiss lender Credit Suisse had done the same thing.
This is not a UK-only problem. Credit Suisse has also stopped acting as a primary dealer in most European countries and this year Bank of Tokyo-Mitsubishi UFJ — Japan’s biggest bank — resigned from underwriting Japanese government bonds.
“There are enough other banks to keep on buying and selling government [debt] so the situation is not yet problematic,” says Francis Diamond, UK rates strategist at JPMorgan. “But if you are responsible for placing a government’s debt in markets then it’s a trend that you need to keep an eye on.”
Don’t write off gilts
In an attempt to support the gilt market, the DMO tweaked its rules. Market makers were asked to put forward larger bids and the UK opted to hold smaller, more frequent, auctions to ease pressure on bank balance sheets. For a few weeks, things calmed down. Then the Brexit vote on June 23 created a fresh market shock that pushed sterling down to a 31-year low. But in spite of the concerns about liquidity, rising debt levels and the as yet unscripted exit from Europe, demand for gilts in secondary markets remained robust.
Andrew Balls, chief officer for fixed income at Pimco, says demand from pension funds — that need to match liabilities and meet the demands of regulators by investing in gilts — will act as ballast for the market even in the midst of currency weakness.
“Sterling is a thermometer for the UK, but weakness in the currency does not mean a sell-off in all UK assets,” he says.
Larry Hatheway, chief economist at asset manager GAM, agrees. Although international investors reduced their holdings of gilts by £4.4bn in July, domestic investors easily made up the shortfall, keeping pressure on gilt yields. “The gilt market looks to be well supported,” he says.
Writing gilts off has proven costly for investors in the past. In 2010, Bill Gross, then manager of Pimco, the world’s largest bond fund, cautioned investors to avoid UK government securities, describing them as “resting on a bed of nitroglycerine” thanks to high levels of government debt and the potential for sterling to fall.
Yet by that summer the bond manager had reversed its stance in the face of a sustained gilt rally, switching from underweight to neutral.
The extent of this year’s gilt rally has again left some investors anxious. For the first time, yields on two short-dated gilts briefly traded in negative territory — meaning investors were willing to pay more to own government bonds than they would get back in interest and capital repayment.
It means, says John Wraith, head of UK rates strategy at UBS, that parts of the market cannot shake off the feeling that they will look back in a year and realise “they were the mugs who bought gilts at the most expensive prices in