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Funding issues and debt management. David Miles, with Laurence Mutkin and Rustom Irani. 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

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funding issues and debt management

Funding issues and debt management

David Miles, with Laurence Mutkin and Rustom Irani

summary
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
gilt issuance the dmo s illustrative projections based on pre budget report forecasts
Gilt issuance: the DMO’s illustrative projections based on Pre-Budget Report forecasts

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

Illustrative gross gilt sales

62.5

62

46

47

57

57

.

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

outlook for gross gilt issuance
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

gilt supply
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 inflation-linked bonds, in response to persistent demand for long-duration nominal and real assets.
  • But long-dated yields remain low in relative and absolute terms
national debt as a proportion of national income since 1855
National debt as a proportion of national income since 1855

Figure 6.1

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

long term real interest rates on uk conventional debt
Long term real interest rates on UK conventional debt

Figure 6.4

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.

conventional gilt sales according to maturity type
Conventional gilt sales according to maturity type

Figure 6.5

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.

composition of stock of uk government debt
Composition of stock of UK government debt

Figure 6.6

Notes: Measures based on nominal (uplifted) par amounts of outstanding debt at end March..

Source: Debt Management Office.

sources of demand db pension system
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)

sources of demand boe open market operations
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

the outlook
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?

gilt portfolio maturity and duration
Gilt portfolio maturity and duration

Figure 6.7

Source: Debt Management Office

average spot yield curves on 18th of january 2007
Average spot yield curves on 18th of January 2007

Figure 6.8

Source: Bank of England

the dmo s modelling results composition of nominal issuance strategies
30-year nominal

1-year nominal

10-year nominal

5-year nominal

bond

bond

bond

bond

The DMO’s modelling results Composition of nominal issuance strategies

Table 6.7

Strategy 1

17.5%

17.5%

30.0%

35.0%

Strategy 2

35.0%

30.0%

35.0%

Strategy 3

50.0%

50.0%

Strategy 4

100.0%

.

Debt Management Office

simulation results for nominal issuance strategies
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

Debt cost/GDP over the interval t=400 to t=500

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

Notes: Figures are quarterly, annualised and expressed in percentage points.

Source: Debt Management Office

composition of further issuance strategies
30-year nominal

1-year nominal

10-year nominal

5-year nominal

bond

bond

bond

bond

Composition of further issuance strategies

Table 6.9

Strategy 5

17.5%

17.5%

30.0%

35.0%

Strategy 6

35.0%

30.0%

35.0%

Strategy 7

50.0%

50.0%

Strategy 8

100.0%

.

Source: Debt Management Office

slide19
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

Debt cost/GDP over the interval t=400 to t=500

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

Notes: Figures are quarterly, annualised and expressed in percentage points.

Source: Debt Management Office

what if the dmo just issued long bonds
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
corporate debt as a proportion of domestic production
Corporate debt as a proportion of domestic production

Figure 6.9

Source: Office for National Statistics

bonds issued as a proportion of non financial institutions debt
Bonds issued as a proportion of non-financial institutions’ debt

Figure 6.10

Source: Office for National Statistics

breakdown of household debt
Breakdown of household debt

Figure 6.11

Source: Office for National Statistics

value of fixed rate mortgages as proportion of all mortgages
Value of fixed rate mortgages as proportion of all mortgages

Figure 6.12

Notes: Includes the stock of both capped and fixed-rate mortgages.

Source: CACI Mortgage Market Database

the maturity and duration of debt and monetary policy
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 shorter-term 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.
summary26
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.

summary27
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.

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