Investors are bracing for the UK government to unleash a “cataclysmic” flood of debt sales over the next few years, leaving many wondering who exactly will buy all the gilts – and at what price.
Even after scrapping his predecessor’s unfunded tax cuts – which triggered a bond market meltdown in September – Chancellor Jeremy Hunt faces a daunting task of borrowing. The cost of subsidizing household energy bills, paying creaking utilities as the economy heads into recession and servicing an inflated interest bill from past borrowing has set the stage for a half-decade bond sales that will dramatically increase – and permanently reshape – the £2,000,000 gilt market.
The Debt Management Office – which handles bond sales on behalf of the Treasury – will need to sell an average of nearly £240bn worth of gilts for each of the next five financial years, according to Citigroup forecasts. This figure comfortably eclipses previous records, with the exception of extensive borrowing during the coronavirus pandemic.
The Bank of England has scooped up the majority of gilts coming to market in 2020 with its quantitative easing program of bond purchases, effectively funding the government’s unprecedented borrowing needs. Now, by contrast, a BoE faced with runaway inflation is rolling back its more than £800bn quantitative easing program by reselling bonds to investors.
“When we had a lot of issuance before the BoE was there to mop it up,” said Mike Riddell, bond portfolio manager at Allianz Global Investors. “Now you could have almost everyone selling. The question is, who will buy?
Robert Stheeman, who heads the DMO, told MPs in October that “from now on. . . the net issuance in the market will be the highest in history”.
However, there are few outward signs of anxiety in the markets. The Gilts rebounded from the September and October rout, helped by plans by Hunt and new Prime Minister Rishi Sunak to restore public finances to a sustainable footing. The yield on 10-year gilts – a benchmark for government borrowing costs – sits just above 3%, after climbing as high as 4.5% during the pension fund liquidity crunch which followed former Chancellor Kwasi Kwarteng’s unfortunate ‘mini’ budget.
For some analysts, the calm in the government securities market is a reminder that bond supply expectations have never been the main driver of returns in the major bond markets of the developed world – the movements of which can generally be largely explained by changes in interest rate expectations. Either way, the UK isn’t alone — the energy crisis is set to spur record emissions in the eurozone next year.
Still, some fund managers say investors have opted to focus on reducing gilt issuance in the current fiscal year following Hunt’s fall budget statement last month, and are burying head in the sand facing the coming avalanche.
“I don’t think the market has quite accepted the magnitude of it all,” said Craig Inches, head of rates and liquidity at Royal London Asset Management. “It’s cataclysmic.”
Ownership of the gilt market is split roughly evenly between domestic investors, foreign investors and the BoE – which has swallowed the lion’s share of additional issuance as the size of the market has tripled since the 2008 global financial crisis. 09. As the central bank shifts from buyer to seller, it falls to the private sector, at home and abroad, to absorb the next wave of bond sales.
“The best of worlds”
UK-based investors may struggle to pick up the slack. Pension funds have traditionally dominated the longer-term part of the gilt market. Over the past two decades, DMO has responded to the relentless demand from so-called responsibility-oriented investors – retirement strategies that use long-term assets to match their long-term commitments to retirees and have been central to the fall gilt market chaos . As a result, gilts have a much longer average maturity than other major bond markets – over 14 years, compared to six to eight years in other G7 economies.
The rapid rise in bond yields at the end of September sent shockwaves through an LDI industry that had been full of leveraged bets on lower rates, forcing investors to sell more gilts to raise cash, creating this which the BoE called a “self-reinforcing spiral”. The central bank was forced to step in and support the market with £19bn of long-term gilt purchases, while Hunt’s borrowing reversal also helped calm the market.
However, now that its liquidity crunch has eased, the sector’s overall solvency is healthier thanks to higher bond yields, according to Daniela Russell, head of UK rates strategy at HSBC. This could lead to a wave of demand as LDI managers buy gilts to lock in their improved funding position. However, the longer-term decline of the defined-benefit industry — these plans are mostly closed to new members — means this source of demand will decline, Russell said.
Officials concede that the structure of gilt issuance will likely need to change to reflect the pullback from an industry that was hungry for gilt at any price, with bond sales less focused on ultra-long maturities than before. .
“For the past 20 years, non-economic investors have bought because they had to,” Riddell said. “It’s been a grant to the UK government, and I think it will be removed. You’ll see the UK curve look more like everyone else’s.
This forces the UK to woo overseas buyers like never before. Even maintaining current levels of foreign ownership will require much higher demand. If foreign investors were to buy at the same pace in 2023 as they did in 2022, they would only absorb 15% of gilts issued in 2023, instead of their historical 30%, according to Kim Hutchinson, global rates portfolio manager at JPMorgan La asset management.
Many investors claim that the DMO will have to pay for the lien with higher borrowing costs.
“We are in this brave new world of the BoE determined to reverse QE,” said Quentin Fitzsimmons, lead portfolio manager at US asset manager T Rowe Price. “It means we are more dependent than ever on the ‘kindness of strangers,'” he added, referring to former BoE Governor Mark Carney’s description of the UK’s dependence on foreign sources. flows of foreign capital to finance its budget and current account deficits.
According to Fitzsimmons, current UK yield levels are not attractive to global investors. Yields on gilts briefly exceeded those on equivalent US Treasuries during recent crises. They will probably have to do it again and settle there permanently in order to attract enough foreign buyers, he said.
Transferring sufficient amounts of bonds to investors will also be a test for market infrastructure. Last week there was daily gold selling by the DMO or the BoE, a schedule that is likely to repeat itself this week. That could become the norm as annual issuance tops £200bn over the next few years, according to Barclays bond strategist Moyeen Islam.
The DMO could be forced to conduct more syndications, in which it pays banks to place large amounts of debt with investors, or increase the size of its auctions, which would worsen the market disruption caused. through the supply of new bonds and ultimately force the government to pay higher borrowing costs.
“I would say that given the numbers we are looking at for the next few years, we are at the limit of market capacity,” Islam said.
During his appearance before the House Treasury Committee in October, Stheeman was very confident of selling as many gilts as the government requires, but added that he could not guarantee the process would always go smoothly.
The coming slowdown could actually make things easier for him, if it causes the BoE to raise interest rates less aggressively, or even cut them.
“Ultimately, if we’re 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 the markets are now allergic to large-scale borrowing. Rather, it was the former Chancellor’s decision to fire the top Treasury official and publish his budget without scrutiny by the official watchdog that undermined confidence in Britain’s economic management.
Hunt, on the other hand, has so far been able to get away with his borrowing plans because the markets understand the reasons behind them. Rather than announce tax cuts at a time of high inflation, the new Chancellor was forced to issue giant gilts due to dire economic prospects and the Treasury’s need to compensate the BoE for losses on its portfolio. QE as interest rates rise.
“The numbers are certainly significant,” Islam said. “But September reminds us that context matters and narrative matters in markets. You must have a story that investors are ready to buy.