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The Green Budget. Funding issues and debt management. January 2005 Professor David Miles +44 20 7425 1820 [email protected]

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The green budget

The Green Budget

Funding issues and debt management

January 2005

Professor David Miles +44 20 7425 1820 [email protected]

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.


Overview

Overview:

  • Much more government debt is likely to be issued over the next five years than over the last five. Demand from insurance and pension funds should be strong; UK issuance is likely to remain below that of the largest euro area countries.

  • The Debt Management Office has pursued a simple, predictable and transparent funding strategy, issuing debt across the maturity spectrum to achieve a relatively smooth redemption profile.

  • There is a strong argument for the government to issue a much higher proportion of long-dated and index-linked debt. The relative shortage of this sort of debt may be keeping long rates unusually low.

  • The government might also find it attractive to become active in the options market and to encourage the issuance of bonds linked to life expectancy. But whether it should itself issue longevity bonds is much less clear.


Public sector net borrowing

Public sector net borrowing

£ billion

2003-4

2004-5

2005-6

2006-7

2007-8

2008-09

2009-10

PBR

34.8

34.2

33.4

29.0

28.0

24.0

22.0

Base case 1

34.8

34.4

36.7

40.9

40.9

39.2

37.4

MS central case

34.8

34.4

39.6

42.9

41.1

39.7

38.1

MS Sharp rise in household saving

34.8

34.4

49.2

65.0

73.6

80.7

88.5

1) Base case refers to IFS estimates based on PBR economic forecasts

Source: IFS, Morgan Stanley Research estimates, HM Treasury


Public sector net debt

% of GDP

2003-4

2004-5

2005-6

2006-7

2007-8

2008-09

2009-10

PBR

32.9

34.3

35.4

36.2

36.8

37.0

37.1

Base case1

32.9

34.3

35.7

37.4

38.9

40.1

41.0

MS central case

32.9

34.3

35.9

37.8

39.3

40.6

41.7

MS worse case

32.9

34.3

36.7

40.4

44.3

48.4

54.5

Public sector net debt

(1) Base case refers to IFS estimates based on PBR economic forecasts

Source: IFS, Morgan Stanley Research estimates, HM Treasury


Gilt issuance the dmo s pre budget report projections

£ billion

2004-05

2005-06

2006-07

2007-08

2008-09

2009-10

Central Government Net Cash requirement1

40

36

31

28

25

28

Redemptions2

15

15

30

29

15

16

Financing Requirement3

54

50

61

57

40

44

Illustrative Gross Gilt Sales4

50

48

59

55

38

42

Gilt issuance: the DMO’s Pre-Budget Report projections

Notes: 2004-05 estimate of gross gilt sales is from the PBR; other projections assume national savings and investments run at £2 billion a year and that other factors (e.g. changes in public sector net cash position and changes in the stock of Treasury Bills) have zero net impact.1, 2, 3: Source: DMO

4. Source: Morgan Stanley Research Estimates based on DMO projections


Outlook for gross gilt issuance

£ billion

2004-5

2005-6

2006-7

2007-8

2008-09

2009-10

DMO/PBR illustrative gilt sales

50

48

59

55

38

42

Base case1

50

52

71

68

53

57

Morgan Stanley central case

50

54

73

68

54

58

Morgan Stanley worse case

50

64

95

101

95

109

Outlook for gross gilt issuance

1) Base case refers to IFS estimates based on PBR economic forecasts

Source: HM Treasury, IFS, Morgan Stanley Research


Projections for net and gross debt issuance

Projections for net and gross debt issuance

1) Base case refers to IFS estimates based on PBR economic forecastsSource: IFS, Morgan Stanley and DMO


The scale of gilt issuance

The Scale of Gilt Issuance:

  • The projections are based on an assumption of no change in tax rates and spending plans – so they exaggerate the likely scale of gilt issuance.

  • But more debt is likely.

  • It is helpful to put that in the context of demand from UK institutions and with an eye on the size of bond issues from other European governments.


The scale of gilt issuance1

The Scale of Gilt Issuance:

  • UK insurance companies and pension funds hold gilts with a market value of around £220 billion – almost two-thirds of all outstanding gilts. These bonds make up around 14% of the financial assets held by pension funds and insurance companies

  • On the basis of our projections, net new issues of gilts over the next few years will average somewhere around £40 billion a year. This would be about 2.5% of the gross financial assets of UK insurance companies and pension funds.

  • If there were to be no growth at all in the overall assets of insurance companies and pension funds and if such institutions were to buy all net new gilt issues – both extreme assumptions – their holdings of gilts would rise from around 14% of all their assets today to between 19% and 21% by 2007–08.


Emu4 government bond issuance

700

EUR bn

Gross Issuance

Redemptions

600

Net Issuance

500

400

300

200

100

0

1999

2000

2001

2002

2003

2004

2005E

2006E

2007E

2008E

2009E

2010E

EMU4 government bond issuance

Billion euros

E = Morgan Stanley Research estimatesSource: National Treasuries, Morgan Stanley Research


Emu 4 government bond issuance 1999 2010e

EMU 4: Government Bond Issuance, 1999-2010e

2000

2001

2003

2005e

2006e

2009e

2010e

1999

2002

2004

2007e

2008e

Across Countries

Germany

100

97

142

154

157

101

154

166

177

194

196

192

France

81

90

101

118

122

111

132

110

123

144

114

90

205

183

194

214

190

168

166

193

177

222

191

157

Italy

38

35

35

34

38

38

28

24

25

37

32

32

Spain

Gross Issuance

423

380

405

472

520

504

475

492

503

518

599

529

Redemptions

271

270

309

332

388

340

338

363

364

367

436

357

Net Issuance

152

110

97

140

133

165

137

128

139

151

164

172

E = Morgan Stanley Research estimatesSource: National Treasuries, Morgan Stanley Research


Optimal debt management

Optimal Debt Management:

  • At present, the remit from the government to the Debt Management Office (DMO) is that it should seek ‘To minimise over the long term the costs of meeting the Government’s financing needs, taking into account risk, whilst ensuring that debt management policy is consistent with the aims of monetary policy’

  • To meet this remit, the DMO has pursued a relatively simple, predictable and transparent funding strategy that has not explicitly involved targeting issuance at types of debt where there appears to be strongest demand. Gilts have been issued across the maturity spectrum and with an aim that there is a relatively smooth redemption profile. There has been little use of derivatives.


Average lives of stocks of government debt

Average lives of stocks of government debt

years

Source: Thomson Financial


Composition of outstanding gilts 1999 2004

At end-March

1999

2000

2001

2002

2003

2004

Conventional

0-3 years

16

17

17

18

16

16

3-7 years

22

22

22

18

19

19

7-15 years

24

19

16

17

18

19

Over 15 years

15

16

17

20

19

21

Total

76

75

73

73

73

74

Index-linked*

21

23

25

26

27

25

Undated

1

1

1

1

1

1

Floating rate

1

1

1

0

0

0

Composition of outstanding gilts 1999-2004

* including index-linked uplift;

Source: DMO


Debt management

Debt Management:

  • On risk grounds there is a strong argument for the government issuing long debt and with a high proportion in index linked terms.

  • This is probably what the optimal tax smoothing policy looks like (Barro).

  • Fortunately there is no conflict with the aim of minimising expected cost since long gilts look expensive (to buy) and cheap (to sell).


Real yields on 20 year uk government index linked bonds

1986

3.95

1991

4.49

1996

3.62

2001

2.31

1987

4.16

1992

3.85

1997

3.05

2002

2.13

1988

3.97

1993

3.01

1998

2.05

2003

2.01

1989

3.80

1994

3.87

1999

1.86

2004

1.50

1990

4.38

1995

3.56

2000

1.89

Real yields on 20 year UK government index linked bonds

Source: Bank of England estimated real spot yield curve (end year levels of yield)


Long dated real and nominal yields

Long dated real and nominal yields

Source: FinCad/Reuters


Forward rate on euro and sterling government bonds december 2004

Forward rate on euro and sterling government bonds: December 2004

Source: FinCad/Reuters


Gbp and eur 15year ahead 15year forward rates

GBP and EUR 15year ahead 15year forward Rates

% rate

Source: Morgan Stanley


Use of new instruments options and longevity bonds

Use of New Instruments? Options and Longevity Bonds

  • If it were able to provide liquidity to the long-dated options market by issuing calls or swaptions (an option to enter into a swap transaction), government could be smoothing the costs of its own funding.

  • A call, or a swaption that gives the holder the right to receive a flow of fixed-rate payments at some point in the future, is an instrument whose value to the holder rises the lower are interest rates on bonds.

  • The issuer of such options receives a premium and then only faces a future cost if bond yields fall below some given level in the future. Government would be issuing securities whose net profits are positively linked to the cost of its own future debt issuance, which is likely to be a risk-reducing strategy.

  • It would help in hedging fix rate mortgages and generate securities in short supply for those seeking long bonds ultimately backed by real assets.


Sample contract terms indicative 10yr 20yr swaption terms

Sample Contract Terms — Indicative 10yr – 20yr Swaption Terms

Option Buyer:Counterparty

Option Seller:HM Treasury

Trade Date:11 Jan 2005

Option Maturity11 Jan 2015

Swap Maturity11 Jan 2035

Strike:At The Money (4.475%)

Notional:£1,000,000,000

Option Type:European Receiver

Upfront Premium:£55,340,000

Current forward starting swap rate (10yr – 20yr):4.475%

Breakeven swap rate:3.85%

i.e. as long as the 20yr swap rate in 10 years time remains at or above 3.85% HM Treasury will not face any net all-in expense.

Source: Morgan Stanley


20yr historical gbp swap rate

20yr historical GBP swap rate

Source: FinCad/Reuters


Use of new instruments options and longevity bonds1

Use of New Instruments? Options and Longevity Bonds

  • Willetts (2004) and King (2004) have argued that there is likely to be a role for the government in providing longevity bonds.

  • Is the government already substantially exposed to longevity risk so that if life expectancy rises in an unanticipated way, its fiscal position worsens because pressure on spending rises relative to tax revenues? This is an issue that the tax-smoothing arguments of Barro suggest is crucial.

  • Is the scope to spread longevity risk across different cohorts alive at the same time (something that private financial markets can do) so limited that the greater part of risks have to be handled by government if they are to be spread much more evenly?


Use of new instruments options and longevity bonds2

Use of New Instruments? Options and Longevity Bonds

  • The UK government relies much more on taxes on labour income than on taxes on capital income and spends a large amount on healthcare; it also has substantial obligations to pay public sector pensions. This suggests vulnerability to increase in life expectancy if that raises the proportion of time people spend out of employment and raises the demands upon the health system.

  • While the ability of financial markets to spread longevity risk across the population is limited to those alive, this still presents scope to spread risk much more widely than it now is. Currently, much longevity risk is concentrated in particular places.

  • Risk sharing between the relatively old and the relatively young is potentially highly advantageous. In principle, it can be achieved through trading in financial markets.


Use of new instruments policies

Use of New Instruments? Policies

  • There are a number of areas where the government could potentially provide assistance to get a private market in longevity bonds going:

  • At the moment, there are estimates from the Government Actuary’s Department (GAD) on life expectancy, but these are updated relatively infrequently. They have also in the past severely underestimated longevity.

  • The Financial Services Authority could consider a policy of allowing for regulatory capital relief to those who have exposure to longevity risk but hold longevity bonds to hedge it.

  • Pension Protection Fund relief could be provided for funds that hedged their mortality risks.


Disclaimers

Disclaimers


Disclaimers1

Disclaimers

ANALYST STOCK RATINGS

Overweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.

More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst’s view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner.

Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.

ANALYST INDUSTRY VIEWS

Attractive (A). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark named on the cover of this report.

In-Line (I). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark named on the cover of this report.

Cautious (C). The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark named on the cover of this report.

Stock price charts and rating histories for companies discussed in this report are also available at www.morganstanley.com/companycharts. You may also request this information by writing to Morgan Stanley at 1585 Broadway, 14th Floor (Attention: Research Disclosures), New York, NY, 10036 USA.


Disclaimers2

Disclaimers

Other Important Disclosures

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For a discussion, if applicable, of the valuation methods used to determine the price targets included in this summary and the risks related to achieving these targets, please refer to the latest relevant published research on these stocks. Research is available through your sales representative or on Client Link at www.morganstanley.com and other electronic systems.

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Disclaimers3

Disclaimers

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