Funding issues and debt management
David Miles, with Laurence Mutkin and Rustom Irani
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Summary
• Implications of the Budget for Gilt issuance in FY 2007-8 and beyond
• The outlook for Gilt market during FY 2007-08
 Supply vs demand: issuance; pension funds; Bank of England
 Issuance options for the DMO
 The case for further issuance of very long maturity bonds
 Alternative funding instruments: longevity bonds?
• Medium term issues
 The changing debt structure and the transmission mechanism of monetary
policy
 Tax relief on interest payments
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Gilt issuance: the DMO’s illustrative projections based
on Pre-Budget Report forecasts
5/30/2016
Table 6.3
£ billion
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
Central government
net cash requirement
41.2
35
31
33
29
32
Redemptions
29.9
29
17
16
30
27
Financing
requirement
71.1
64
48
49
59
59
Other sources of
financing
-8.6*
-2
-2
-2
-2
-2
62.5
62
46
47
57
57
Illustrative gross
gilt sales
.
Note: 2006–07 financing requirement and estimate of gross gilt sales are from the PBR; *includes proceeds
from restructuring balance sheet of British Nuclear Fuels (BNFL) and sales of national savings net of the
reduction in the stock of Treasury bills; other projections assume national savings and investments run at £2
billion a year and that other factors (for example, changes in the public sector net cash position and changes
in the stock of Treasury bills) have zero net impact.
Sources: Debt Management Office; Morgan Stanley Research
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Outlook for gross gilt issuance
Table 6.4
£ billion
2006-07
2007-08
2008-09
2009-10
2010-11
2011-12
DMO/PBR illustrative
gilt sales
62.5
62.0
46.0
47.0
57.0
57.0
IFS base case
63.8
63.9
49.8
48.6
56.3
56.4
Morgan Stanley
central case
63.5
65.0
49.9
47.4
54.1
51.7
Morgan Stanley
pessimistic case
63.6
65.0
54.6
54.8
62.7
59.4
.
Notes: The alternative projections in Table 6.4 to the PBR/DMO illustrations are not really forecasts of what
gilt sales would be since they are based on an assumption of unchanged spending plans and tax rates.
Sources: IFS; Morgan Stanley Research; HM Treasury
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Gilt Supply
• Somewhat higher issuance than government predicts is possible: but the
level of debt/GDP remains entirely manageable, and consistent with historic
norms
• Higher issuance has not driven gilt yields higher – on the contrary, they
remain at historic lows
 The DMO has skewed issuance to long-maturity conventional and inflationlinked bonds, in response to persistent demand for long-duration nominal
and real assets.
 But long-dated yields remain low in relative and absolute terms
5
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National debt as a proportion of national income since
1855
Figure 6.1
300
Percent of national income
250
Government debt to GDP ratio
200
150
100
50
0
1855
1881
1907
1933
1959
1985
2011
Notes: Pre-1974 series is gross nominal liabilities of the National Loans Fund (formerly known as the
National Debt). 1974 onwards it is the General Government Gross Debt.
Source: HM Treasury, Office for National Statistics
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Long term real interest rates on UK conventional debt
Figure 6.4
6%
Average long-term real interest rates
5%
Long-term average (1700-2005)
Real Yield
4%
3%
2%
1%
0%
17001749
17501799
18001849
18501899
19001939
19601969
19701979
19801989
19901999
20002005
2006
Notes: Nominal 2.5% consol rate less long term inflation expectations; 1940-59 is omitted from the figure
because rationing during this time period made price data unreliable, leading to a negative real long-term
interest rate.
Source: Morgan Stanley Research. Estimates of real yields are based on the nominal yield on consols net of
a measure of expected inflation over the coming 10 years. For a detailed description of the method used to
construct the real yields see “Where should long-term interest rates be today? A 300 year view”, David Miles
a, Melanie Baker and Vladimir Pillonca, March 2005, Morgan Stanley research.
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Conventional gilt sales according to maturity type
Figure 6.5
-160
-140
Short
Medium
Long
5s30s
-120
-100
60%
-80
-60
40%
-40
Basis points
80%
-20
20%
0
20
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
40
1999-00
0%
1998-99
Percentage of overall debt portfoilio
100%
Notes: 5s30s (right axis) is defined as the yield of a typical 30-year government bond less the yield of a
typical 5-year government bond. The axis is inverted.
Source: Debt Management Office.
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Composition of stock of UK government debt
Figure 6.6
100%
Conventional
Percentage of overall debt portfoilio
Index-linked
75%
50%
25%
0%
2000
2001
2002
2003
2004
2005
2006
Notes: Measures based on nominal (uplifted) par amounts of outstanding debt at end March..
Source: Debt Management Office.
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International real yields on inflation-proof
Figure 6.3
4.0%
3.875% TIPS 2029 (US)
3.5%
3.4% OATi 2029 (EU)
Real Yield
3.0%
4.125% IL 2030 (UK)
2.5%
2.0%
1.5%
1.0%
Jan-01
Jan-02
Source: Bloomberg.
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
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Sources of Demand – DB Pension System
• DB pension system size: approx GBP 750 bn
For Purple Book sample (85% of schemes by value)
• allocation to bonds: approx 28%
 Aggregate s 179 deficit: £33.8bn
 Aggregate sensitivity of scheme funding to 0.01 move in Gilt yields: £1.3bn
A source of continuing demand for very long duration nominal and real Gilts
(and derivatives)
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Sources of Demand – BoE Open Market Operations
• OMO reform: gradual switch from repurchase operations to outright
purchases
• In “ramp up” phase: purchases of £4bn per year for first three years
 Likely to begin before the end of calendar 2007
A source of steady demand for nominal Gilts between 5- and 20-years to maturity
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The Outlook
• Gross gilt issuance in 2007-08 is likely to be similar to that in 2006-07: the
outlook for future years is for a substantial reduction, thanks to falling
redemptions
• Expect issuance to continue to follow recent years’ pattern: become skewed
to long-dated conventional and inflation-linked Gilts, in response to strong
demand
 Demand for long-dated duration from pension funds will continue
 Bank of England to become a marginal but consistent buyer across maturities
So what is an optimal debt issuance strategy?
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Gilt portfolio maturity and duration
Figure 6.7
15
Portfolio maturity
Percentage of overall debt portfoilio
14
Conventional (duration)
13
Index-linked (duration)
Portfolio duration
12
11
10
9
8
7
6
1998
1999
2000
2001
Source: Debt Management Office
2002
2003
2004
2005
2006
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Average spot yield curves on 18th of January 2007
Figure 6.8
6
Implied inflation
Nominal yield
5
Real yield
Percent
4
3
2
1
0
2.50
5.00
7.50
10.00
12.50
15.00
17.50
20.00
22.50
25.00
Years to maturity
Source: Bank of England
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The DMO’s modelling results
Composition of nominal issuance strategies
5/30/2016
Table 6.7
1-year nominal
bond
Strategy 1
17.5%
Strategy 2
Strategy 3
Strategy 4
5-year nominal
bond
10-year nominal
bond
30-year nominal
bond
17.5%
30.0%
35.0%
35.0%
30.0%
35.0%
50.0%
50.0%
100.0%
.
Debt Management Office
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Simulation results for nominal issuance strategies
Table 6.8
Strategy 1
Strategy 2
Strategy 3
Strategy 4
Debt cost/GDP at t=500
Mean
1.41
1.43
1.41
1.39
Standard deviation
0.20
0.20
0.20
0.19
95th percentile
1.75
1.76
1.74
1.72
Mean mean
1.42
1.43
1.41
1.39
Mean standard deviation
0.20
0.20
0.20
0.19
Mean 95th percentile
1.73
1.77
1.74
1.71
Debt cost/GDP over the
interval t=400 to t=500
Notes: Figures are quarterly, annualised and expressed in percentage points.
Source: Debt Management Office
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Composition of further issuance strategies
Table 6.9
1-year nominal
bond
Strategy 5
5-year nominal
bond
17.5%
Strategy 6
Strategy 7
Strategy 8
10-year nominal
bond
30-year nominal
bond
17.5%
30.0%
35.0%
35.0%
30.0%
35.0%
50.0%
50.0%
100.0%
.
Source: Debt Management Office
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Simulation results for further issuance strategies with shares of
inflation-linked bonds (with accrued compensation on principal)
Table 6.10
Strategy 5
Strategy 6
Strategy 7
Strategy 8
Debt cost/GDP at t=500
Mean
1.42
1.42
1.41
1.38
Standard deviation
0.21
0.21
0.21
0.27
95th percentile
1.80
1.77
1.79
1.83
Mean mean
1.41
1.42
1.41
1.39
Mean standard deviation
0.21
0.21
0.22
0.28
Mean 95th percentile
1.78
1.77
1.78
1.85
Debt cost/GDP over the
interval t=400 to t=500
Notes: Figures are quarterly, annualised and expressed in percentage points.
Source: Debt Management Office
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What if the DMO just issued long bonds?
• Unless offset by companies and households moving to shorter maturity and
duration debt it would continue to lengthen the overall stock of debt.
 This has potential implications for monetary policy
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Corporate debt as a proportion of domestic production
Figure 6.9
Per cent of national income
100%
90%
Corporate debt
80%
Corporate bonds
70%
Corporate loans
60%
50%
40%
30%
20%
10%
0%
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
1990 1992 1993 1994 1995 1997 1998 1999 2000 2002 2003 2004 2005
Source: Office for National Statistics
21
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Bonds issued as a proportion of non-financial
institutions’ debt
Figure 6.10
28%
26%
24%
%Corporate bonds/debt
Percent
22%
20%
18%
16%
14%
12%
10%
Q1
Q2
Q3
Q4
Q1
Q2
Q3 Q4
Q1
Q2
Q3
Q4
Q1
Q2
1990 1991 1992 1993 1995 1996 1997 1998 2000 2001 2002 2003 2005 2006
Source: Office for National Statistics
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Breakdown of household debt
Figure 6.11
100%
90%
Household debt
Secured debt
Percent of national income
80%
Unsecured debt
70%
60%
50%
40%
30%
20%
10%
0%
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
Q1
Q2
Q3
Q4
1990 1992 1993 1994 1995 1997 1998 1999 2000 2002 2003 2004 2005
Source: Office for National Statistics
23
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Value of fixed rate mortgages as proportion of all
mortgages
Figure 6.12
50%
45%
Per cent
40%
35%
30%
25%
20%
1998
1999
2000
2001
2002
2003
Notes: Includes the stock of both capped and fixed-rate mortgages.
Source: CACI Mortgage Market Database
2004
2005
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The maturity and duration of debt and monetary policy
 Relatively more debt is now longer term and with fixed rates. This is likely
to have affected the impact of monetary policy.
 But it is not clear that there been an absolute reduction in the effectiveness of
monetary policy.
 In part this is because the sensitivity of longer-term interest rates to shorterterm rates – or more generally to monetary policy actions (including words that is Bank of England statements, reports and speeches) - is significant.
 Even if we ignore this channel it is still the case that the absolute amount of
variable rate debt, relative to national income, has almost certainly risen.
 We conclude that the rising maturity and duration of debt – increasing fixity
of interest rates – has not reduced the effectiveness of monetary policy.
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Summary
• In recent years the UK government’s cost of borrowing has been falling in
both nominal and real terms, even though the amount it has borrowed has
been rising and has consistently exceeded its own forecasts.
In the light of this, we should not expect a big impact on the cost of debt if
the government issues a few billion pounds more than its central forecasts.
• Modelling the impact of random factors on different debt issuance strategies
provides strong reasons to favour a strategy involving greater issuance of
long-dated conventional and long-dated indexed debt.
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Summary
 Despite the potentially large cost that the ultimate holders of longevity risk
might need to be compensated with, it is not at all clear that this reflects a
market failure. There remains a rather weak case for government action in
this area.
• Removing the ability of non-financial companies to deduct interest payments
from the measure of profits on which they pay corporation tax might allow
the rate of corporation tax to be cut from 30% to 20% with no net loss of
revenue.
27