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The UK press: confusing demand for price discovery

Much of the UK media just cannot leave the prospect of an uncovered — or, to use the common but incorrect parlance, “failed” — sovereign debt auction alone. Even when the UK Debt Management Office introduces a new mechanism to improve price discovery, stories are littered with references to boosting demand.

The UK DMO kicks off its auction schedule for its 2016-17 financial year this week and, unlike in previous years, its Gilt-edged market makers will not only be expected to buy 2% of all Gilts issued at auction over a six month rolling period, but will also be expected to bid on 5% of Gilts auctioned over the same timeframe.

The reasons for this are pretty clear. Indicating at what price they would be comfortable bidding for GEMMs up to 5% means the GEMMs feed more data into the price discovery mechanism — as the DMO has been at pains to point out.

Such a move is not surprising. At several meetings with investors and GEMMs over the last few months, investors have complained that at times the GEMMs bid prices at auction that do not reflect secondary market reality — these claims were also made at GlobalCapital’s UK DMO roundtable earlier this year.

Whatever side of that argument you take, it is obvious that the DMO is hungry for a smoother price discovery process. And whether or not you believe the new 5% bid expectation will help that, no-one can ever say that this approach has anything to do with boosting demand at auctions.

If the UK really wanted to avoid uncovered auctions — it’s been very close to such an event a few times over the last year — it could adopt the German method of retaining the bonds it doesn’t sell. Then, every auction would be covered — they just wouldn’t be if you took the DMO out of the equation.

Germany frequently has auctions that technically “fail” without the retention factor — and, judging by where Bund yields are, there does not seem to be too much concern about it happening.

Alternatively, the UK could require its GEMMs to ensure that auctions are fully bid — which has obviously not been the case with the latest tweak to the auction process. There are 16 GEMMs, so to ensure auctions are fully bid would require them to bid for a minimum 6.25% — not 5%.

Of course, we cannot say for certain that the UK DMO is not so bad at maths that it just got its numbers wrong, but if this was the case we feel it would have been noticeable a lot earlier than this year.

The “threat of a failed auction” makes for good headlines and a tasty tale for the uninitiated, particularly as it can tie in with the upcoming referendum on European Union membership and its effect on the UK market.

But with its first auction of the financial year on Tuesday, the DMO sold £2.75bn of five year Gilts with a bid to cover ratio of 2.01 — at the upper end of the demand scale over the last year.

Nothing concrete has changed in terms of the EU referendum to make investors suddenly keen to buy British again — but similarly this higher bid to cover ratio cannot be put down to the new GEMM bid expectation. There are a myriad of other factors that are involved.

In the end, sometimes there will be a lot more demand for a particular bond on a particular day, and other days there will be a lot less.

If the latter happens and the bid to cover ratio falls below 1.0, it will not be a “failed” auction. A failed auction is when nothing is sold.

And, even if the UK has an uncovered auction, is it cause for panic? Not really.

At GlobalCapital’s UK DMO roundtable, the institution’s chief executive Robert Stheeman put it best: “I guarantee there’ll be an uncovered auction at one point. I have no clue when that will be, but when it happens I also guarantee that the Earth will continue to turn.”

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