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As investors prepare for the UK government to unleash a “catastrophic” flood of debt sales over the next few years, many are asking who will buy all the gilts — and at what price.
Even after canceling his predecessor’s unfunded tax cuts – which triggered a bond market meltdown in September – Chancellor Jeremy Hunt has a tough task of borrowing. The cost of subsidizing household energy bills, paying for cuts to public services as the economy heads into recession and servicing ballooning interest bills from past debt have set the stage for a half-decade of bond sales that will dramatically expand — and permanently reshape — the £ 2tn Gilt Market.
The Debt Management Office – which manages bond sales on behalf of the Treasury – will need to sell an average of £240bn of gilts over each of the next five financial years, according to Citigroup forecasts. With the exception of massive borrowing during the coronavirus pandemic, that figure comfortably eclipses previous records.
The Bank of England hoovered most of the gilts coming to market in 2020 with its bond-buying quantitative easing program, effectively financing the government’s unprecedented borrowing needs. Today, by contrast, the BoE, facing runaway inflation, is unwinding its more than £800bn quantitative easing scheme by selling bonds back to investors.
“We had a lot of issuance before you had the BoE,” said Mike Riddell, bond portfolio manager at Allianz Global Investors. “Now, you can sell to almost anyone. The question is who will buy?”
DMO chief Robert Steiman told MPs in October that “from now on . . . The net issue in the market will be the highest in history.”
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However, there are few outward signs of concern in the markets. Gilts have bounced back from losses in September and October, helped by Hunts and new Prime Minister Rishi Sunak’s plans to restore public finances to a sustainable footing. The 10-year gilt yield – a measure of government borrowing costs – is just above 3 percent, as high as 4.5 percent amid a pension fund liquidity crisis following former chancellor Kwasi Kwarteng’s ill-fated “mini” budget.
For some analysts, the lull in the gilt market is a reminder that bond supply expectations have never been a key driver of yields in the developed world’s major bond markets — whose moves can usually be largely explained by changes in interest rate expectations. In any case, the UK is not alone – the energy crisis is expected to issue a record across the euro area next year.
However, some fund managers argue that investors have chosen to focus on the fall in gilt issuance in the current financial year as a result of Hunt’s autumn financial statement last month and are burying their heads in the sand on the avalanche to come.
“I don’t think the market is up to the scale of it all,” said Craig Inch, head of rates and cash at Royal London Asset Management. “It’s catastrophic.”
Ownership of the gilt market is roughly evenly split between domestic investors, foreign investors and the BoE – which has swallowed the lion’s share of additional issuance as the market size has nearly tripled since the 2008-09 global financial crisis. As the central bank shifts from buyer to seller, the onus is on the private sector, at home and abroad, to absorb the coming wave of bond sales.
‘Brave New World’
UK-based investors may struggle to capture the downturn. Pension funds have traditionally dominated the long-term end of the gilt market. Over the past two decades DMOs have met relentless demand from so-called liability-driven investors – pension strategies that use long-term assets to match their long-term commitments to pensioners – and were at the heart of the autumn’s gilt market chaos. . As a result, gilts have a much longer average maturity than other major bond markets – more than 14 years, compared with six to eight years in other G7 economies.
A sharp rise in bond yields in late September sent shock waves through the LDI industry which piled on leveraged bets on low rates, forcing investors to sell more gilts to raise cash, in what the BoE called a “self-reinforcing spiral”. The central bank was forced to step in and backstop the market with £19bn of long-dated gilt purchases, while Hunt’s lending U-turn also helped calm the market.
Now that its liquidity crisis has eased, however, the sector’s overall solvency is healthier thanks to higher bond yields, according to Daniela Russell, head of UK rates strategy at HSBC. That could lead to a spurt in demand as LDI managers buy gilts to lock in their improved funding position. However, the long-term decline of the defined benefit sector — such plans are often closed to new members — means this source of demand will decline, Russell said.
Officials admit that the structure of gilt issues is likely to have to change to reflect the retreat of an industry that is hungry for gilts at whatever price, with bond sales less focused on ultra-long maturities than previously.
“Over the last 20 years we’ve had non-financial investors buy in because they had to,” Riddell said. “It’s a subsidy for the UK government, and I think it’s going to go away. You’re going to see the UK curve become the same as everybody else’s.”
This requires the UK to court foreign buyers like never before. Keeping the current level of foreign ownership stable would also require much higher demand. If foreign investors buy at the same pace in 2023 as they did in 2022, they will absorb only 15 percent of the gilts issued in 2023 instead of their historical 30 percent, according to Kim Hutchinson, global rates portfolio manager at JPMorgan Asset Management.
Many investors argue that DMOs have to pay for the privilege with high borrowing costs.
“We’re in this brave new world of the BoE determined to reverse QE,” said Quentin Fitzsimmons, senior portfolio manager at US asset manager T Rowe Price. “It means we are more reliant than ever on the ‘mercy of strangers’,” he added, referring to former BoE governor Mark Carney’s description of the UK’s reliance on foreign capital inflows to finance its budget and current account deficits.
According to Fitzsimmons, current UK yield levels are not attractive to global investors. Gilt yields have risen briefly over the equivalent US Treasuries during the recent crisis. They may have to do so again and settle there for the long term to attract enough foreign buyers, he said.
Transferring enough bonds to investors will also be a test of market infrastructure. Last week there was a daily gilt sale by the DMO or BoE, which is scheduled to repeat this week. That could become the norm with annual issuance topping £200bn for the next few years, according to Barclays fixed-income strategist Moeen Islam.
DMOs may be forced to undertake further syndications, in which they pay banks to place large amounts of debt with investors, or increase the size of their auctions, adding to the market disruption due to the supply of new bonds and ultimately forcing the government. Pay high borrowing costs.
“I would say we’re at the limit of market capacity at the kind of numbers we’re seeing over the next few years,” Islam said.
In his appearance before Parliament’s Treasury Committee in October, Steam was confident the government would sell as many gilts as it needed, but added he could not guarantee the process of doing so would always be easy.
A coming recession may actually make its job easier, if it causes the BoE to raise or cut interest rates less aggressively.
“Ultimately, if we are in a recession, or if today’s inflation turns into tomorrow’s disinflation, demand for bonds will emerge,” Hutchinson said.
Some analysts argue that it would be wrong to conclude from Kwarteng’s fate that markets are now allergic to large-scale borrowing. Instead, it was the former chancellor’s decision to sack a top civil servant at the Treasury and publish his budget without scrutiny from an official watchdog that undermined confidence in the UK’s economic management.
Hunt, by contrast, has been able to get away with its borrowing plans so far as markets understand the reasons behind them. Instead of announcing tax cuts at a time of high inflation, the new chancellor has been forced by a bleak economic outlook to issue jumbo gilts and the Treasury needs to compensate the BoE for losses on its QE portfolio by raising interest rates.
“Numbers are definitely important,” Islam said. “But September reminds us that context matters and narrative matters in markets. You must have a story that investors are willing to buy.
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