The Green Budget: Funding Issues and Debt Management

1. The Green Budget Funding issues and debt management January 2005 Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com 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.

2. 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.

3. 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

4. % 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

5. £ 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

6. £ 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

7. Projections for net and gross debt issuance 1) Base case refers to IFS estimates based on PBR economic forecastsSource: IFS, Morgan Stanley and DMO

8. 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.

9. 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.

10. 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

11. 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

12. 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.

13. Average lives of stocks of government debt years Source: Thomson Financial

14. 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

15. 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).

16. 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)

17. Long dated real and nominal yields Source: FinCad/Reuters

18. Forward rate on euro and sterling government bonds: December 2004 Source: FinCad/Reuters

19. GBP and EUR 15year ahead 15year forward Rates % rate Source: Morgan Stanley

20. 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.

21. Sample Contract Terms — Indicative 10yr – 20yr Swaption Terms Option Buyer: Counterparty Option Seller: HM Treasury Trade Date: 11 Jan 2005 Option Maturity 11 Jan 2015 Swap Maturity 11 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

22. 20yr historical GBP swap rate Source: FinCad/Reuters

23. 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?

24. 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.

25. 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.

26. Disclaimers

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