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Open-minded DMO aims to do right by the market

The UK economy appears to have perked up of late if recent data is anything to go by. Add to that a rise in Gilt yields, and you could be forgiven for thinking that the Debt Management Office, which sells sovereign debt on behalf of the UK, could start to relax about its vast funding programme — especially as it maintains something of a safe haven status among sovereign credits. But the economic recovery needs to be maintained and while international investors appear to be buying an increasing amount of Gilts, the DMO must still navigate the domestic market, which dominates Gilt buying at the long end of the curve. EuroWeek met with DMO chief, Robert Stheeman and a number of key bankers from the Gilt market in London in early September, ahead of the UK’s pioneering 2068 inflation-linked Gilt coming to market, to discuss the outlook for UK sovereign debt.

Participants in the roundtable were:

Charlie Diebel, head of strategy, research, Lloyds Bank 

Sam Hill, UK fixed income strategist, RBC Capital Markets 

Anthony O’Brien, co-head of European rates strategy, Morgan Stanley

David Parkinson, head of UK rates sales, RBC Capital Markets

Dominic Pearson, director, Gilt sales, Lloyds Bank

Daniel Shane, head of SSA, Morgan Stanley

Robert Stheeman, chief executive, UK Debt Management Office

Ralph Sinclair, SSA markets editor, EuroWeek

EUROWEEK: What progress has the DMO made so far this year with its borrowing remit and where are you up to with your syndication programme in particular?

Robert Stheeman, DMO: This year, we have a Gilt sales programme of around £155bn. Our financial year runs from April 1, 2013 to the end of March, 2014, so we are very close to being halfway through and we are also on target to reach the halfway point in our programme

Although our pace of borrowing does vary a little bit at times — that is to say we’ll take our foot off the accelerator at quiet times, such as the summer break or over Christmas — we’re in a particularly busy period now in terms of what we’ve got to raise from the markets. 

The syndication target itself — £21bn — is somewhat flexible. It falls within the overall pot of what we call supplementary issuance. 

We announced on September 6 that we will be looking to launch a new index-linked bond with a March 2068 maturity in the week beginning September 23, subject to market conditions.

The market is expecting that transaction following the previous announcements we’ve made about the quarterly issuance calendar. 

Notwithstanding the fact that markets can be very volatile, things are looking quite positive for that particular syndication. 

We’ve also announced that we plan to hold a syndication in the fourth quarter of the calendar year — a re-opening in October of the conventional 3½% 2068. 

We will be making further announcements about that in due course. 

EUROWEEK: The planned 2068 linker follows on directly from the 2068 conventional Gilt syndication that you did earlier in the year. Did that first syndication lay the groundwork for this?

Stheeman, DMO: We had earlier signalled our intention to introduce what we call super-long issuance, meaning anything longer than 50 years — I apologise repeatedly and profusely for the epithet super-long, it’s just that we ran out of superlatives having used ultra-long already and we couldn’t think of anything else to call it — showing that we were looking to extend, moderately, the maturity spectrum.

This was the result of last year’s consultation on potential super-long issuance. We chose the 2068 maturity a few months ago now, as a result of feedback we received from the market. 

There was no automatic assumption that it should be a 55 year bond. One or two people, at the time, suggested that we might even want to consider going further along the curve, although we got the distinct impression that the universe of investors tends to shrink the further out you go. That applies to the linker market as well. 

Again, there was no hard rule to say just because we’ve issued a 2068 conventional, therefore we had to issue a 2068 linker. But the market feedback pointed overwhelmingly to a 2068 maturity. The presence of the conventional there will help with the hedging for the linker. 

But in choosing these maturities we don’t have any fixed approach. We’ve got an open mind. Once we’ve set the parameters, we try and seek feedback from the market and try and do what we think is best for the programme and best for the market, and those two usually go hand-in-hand.

EUROWEEK: Is there scope to extend the Gilt curve even further than 2068? Is that of benefit to investors?

David Parkinson, RBC Capital Markets: Nobody would rule out a longer-dated issue in the future, but, for the time being, the expectation is that 2068 will be the focus of further issuance, both in conventionals and linkers. 

There’s a finite amount of demand for this very long-dated paper and that might well be satisfied with a few more tranches of 2068 paper.

Pension fund liabilities go all the way out to 80 years or possibly further, but the size of those liabilities diminishes substantially beyond 50 years. 

So, in picking a date to extend the maturity of the yield curve to, the aim is to find a date that will be meaningful in terms of adding an extra hedging instrument for some of those very long liabilities, but without going so far out into the tail that demand is so thin that you would never get to the point where you can build up a liquid issue.

Daniel Shane, Morgan Stanley: The consultation paper that Robert was referring to earlier covered this point about additional interest in maturities further along the curve, including perpetual bonds. 

The feedback that came back at that stage favoured this graduated approach and we’ll have another measure of market demand on the back of the 2068 linker syndication. 

A priority of the DMO will be to ensure the liquidity of this new instrument, bringing it to an increased level of liquidity through re-openings, which I would expect to be a priority, near-term. 

One thing that the DMO is very good at is responding to investor demand and if it becomes apparent as a result of these two syndications that there is sufficient demand for a bond beyond 2068, then it shouldn’t be ruled out. But our near-term expectations are that these two deals are going to be the key sweet spots for investors, in the long end of the curve, and therefore be upsized first.

Stheeman, DMO: Without wishing to pre-empt anything, we do not view these types of issuance strategies as one-offs. Ideally, we look to build new bonds up in size to provide liquidity to the market through re-openings

We don’t want to have any orphans out there. We like our children to remain well brought up with loving parents.

EUROWEEK: When you gather feedback from investors about curve-extending trades, how much of what they say is driven by just matching what they have on the other side of the balance sheet? And how much of it is driven by the need to earn some sort of yield given how low they are?

Stheeman, DMO: In the case of our ultra-long or super-long issuance, it is very much driven by the specific need of the UK pension fund industry to match assets and liabilities, rather than just a vague sense of desiring yield pick-up. It is not that yield pick-up isn’t occasionally present, but the yield curve from 30 years upwards is very flat, if not slightly inverted, and the further along it you go it’s not obvious that you’re going to see much in the way of extra yield pick-up. 

EUROWEEK: Are Gilt investors ringing dealers up complaining about the terrible yields on offer or are they more concerned by other matters?

Parkinson, RBC Capital Markets: No, not at all. Investors are conscious that the Gilt market doesn’t exist in a vacuum — it’s a market like any other that finds a level based on supply and demand. 

One of the key considerations for investors in terms of where they see value is what Gilt yields look like compared to German yields, US Treasury yields. It is the collective judgement of the market that puts yields at the level they’re at. 

There may be times when those yields are at a level which may lead to investors seeking returns elsewhere, but you don’t get people phoning up to complain about the level of yields that the market itself sets. 

Dominic Pearson, Lloyds Bank: Yes, exactly — they have the choice not to buy. 

EUROWEEK: If you’re buying ultra-long sterling products, though, you don’t have much of a choice of what to buy, do you? 

Pearson, Lloyds Bank: In a lot of instances a choice has been exercised for decades not to buy and that is the reason that this situation exists at all. Defined benefit pension schemes have, for a long, long period of time decided to run a material asset and liability mismatch and they’re bearing the historic consequences of that.

There’s nobody they can complain to other than their forebears — it’s a fact of life. What happens in practice is that they’re caught between the need to try to reduce their deficit, so when yields go higher, then they are going to be incentivised.

But when sentiment deteriorates they are then faced with a quandary of whether to bite the bitter bullet or just hope for a better time.

But that’s just the nature of risk and markets. It’s not an acute problem apart for liability-driven investment (LDI) buyers that find themselves in difficult circumstances. 

Moreover, as much as it damages defined benefit pension schemes, one has to bear in mind that the quid pro quo is that the government and future taxpayers benefit from low interest rates, as do other private sector borrowers who are not encumbered by defined benefit pension schemes. 

So, the question to be asked is, to what extent do we need to subsidise one community of the economic world? We just have to make sure that there are vehicles to enable them to hedge their risks, which the DMO provides, and let nature take its course.

Parkinson, RBC Capital Markets: It’s important to remember that long Gilt yields are some 80bp or so above their lows from last year and equities are, perhaps, 25% above their 10 year average levels, so quite recently, there’s been a very substantial improvement in pension fund solvency. Pension funds have been very keen to lock in some of that improved solvency and there’s been an increase in demand for long dated yields, as a result. 

EUROWEEK: What about the outlook for Gilt yields, given the new methodology for setting rates at the Bank of England, the future of QE and so on?

Charlie Diebel, Lloyds Bank: We are entering a very difficult paradigm for UK and European assets because we’re at a different stage of the economic cycle. 

Although the world is talking about the US tapering quantitative easing as if it is tightening policy — and we all know that it’s not, it’s just less accommodation — the changing factor is a potential lessening of support for the markets. 

That is not the case in the UK or eurozone, but markets have always had the US as their prime driver. 

It’s almost impossible for the Bank or any policy maker internationally, to diverge from what’s going on in the US, unless it’s a very domestically captured market. 

Being 96% owned by Japanese investors, the demand and supply conditions of the JGB market can be effectively dictated by the Bank of Japan — the consequence being highly regulated banks and life assurers resulting in a closed market, not really open to international comparison. 

It’s no surprise that you’ve seen such a steepening in the coupon curve there, simply because the market is looking for some insurance. 

The central bank can control the front end of a yield curve, but it can’t control the long end and nor should it try to. It creates all sorts of moral hazards and risks which could make any attempt at it self-defeating. 

While we’re in a world where US data remains strong enough to keep the Fed on this path of considering QE tapering, then it’s going to be very difficult to control where 10 year or longer dated yields go, but the Bank should be able to control where two-year goes.

Anthony O’Brien, Morgan Stanley: The UK economy is not doing so badly itself. We were talking about a triple-dip recession in the UK in April and we’ve moved so far from that since.

Guidance is working. It’s just not working as far out along the curve as we thought it might do. 

I can say guidance is working because we put up our growth forecasts and instead of bringing forward our forecasted date for interest rate hikes, we actually pushed it back, which shows that there is some belief in what Carney’s saying.

However, you can’t take away that the UK economy’s doing exceptionally well, and as long as nothing goes wrong in Europe, the economy probably continues to do OK. And when economies do well, yields tend to rise.

Sam Hill, RBC Capital Markets: The recent change in the policy framework has accentuated the theme of yield curve segmentation. The 10 year part of the curve is still inherently exposed to international developments and because of the gradual improvement in the outlook for the US and the avoidance of some of the more serious crises we’ve seen in the euro area, there has been a rise in core market yields. 

But what Governor Carney attempted to do in his speech in Nottingham on August 28 was to underline that the Bank accepts that although there’s a limited amount it can do about that, they can and will seek to underpin the path of forward rates in the 0-5 year sector. 

While investors will continue to be nervous about longer dated maturities, there is a limit to how much more weakness we could see in the 0-5 year sector because the Bank will likely become uncomfortable if it sees the implied path of market rates rise much further.

Shane, Morgan Stanley: The other interesting element to this, which I’m sure the Bank is going to monitor very closely, is the transfer of Gilt yields into the real economy, in terms of borrowing yields. For example, mortgage rates do not seem to have risen on the back of the sell-off in the Gilt market. If that changes then it might change the Bank’s approach. 

Similarly, corporate and financial borrowers are not seeing their credit terms deteriorate so Gilt yield sell-offs are not something, per se, to be concerned about. They’re a function of an improving economic story at the moment, which has been extremely encouraging. 

It’s in line with other markets and if you look at the developments in the 10 year US Treasury bond yields, the Gilt market is very much in line.

It’s ironic, because the timing of the Nottingham speech and then the sell-off would suggest that neither the speech nor the recent inflation report had an effect. But actually, we would have seen yields higher still if it hadn’t been for them.

Hill, RBC Capital Markets: Another area, where I’m surprised we haven’t seen more of a change in market prices since the inflation report is that we haven’t seen break-even inflation rates retest the wides. We’re still about 25bp off those wides.

Now that the Bank is targeting a real economic variable, we’ll be spending our time looking at the unemployment rate fan chart as much, or more than, the time we will spend looking at the inflation fan chart.

EUROWEEK: Why do you think there’s been a delay?

Hill, RBC Capital Markets: I don’t know but if we continue to see a strong run of economic data and the Bank reinforces its commitment to keep rates on hold, irrespective of that, then over time, we should see that demand for inflation protection increase.

Shane, Morgan Stanley: That’s interesting because a lot has been written about the 7% unemployment trigger. It’s the one variable that everyone’s now quoting and looking at. 

Consensus forecasts are that it won’t be breached until 2016 and yet, the market is pricing in a Bank of England rate hike, probably in 2015, so there is some kind of discontinuity between the two. 

But given the inflation knock-out that the Bank has referred to, it is more likely to be inflation breaching the 2.5% target that triggers a rate hike.

O’Brien, Morgan Stanley: We don’t think it will hit unemployment at 7% until 2016, however we think that there will be rate hikes in mid-2015 because we expect the inflation expectation threshold to be broken. 

We can ignore inflation at the moment to a certain extent, but it will come to the forefront when wage growth starts picking up.

Nobody knows what these inflation expectations are. However, they are going to be the most important thing, and that is where it is most likely that one person will vote against the Monetary Policy Committee. As soon as one person votes against it, forward guidance is dead. 

The other thing about unemployment is that it’s a function of three other factors — immigration, productivity and the participation rate. 

Shane, Morgan Stanley: So is forward guidance not all it’s cracked up to be? 

O’Brien, Morgan Stanley: Forward guidance works for the Fed because QE is happening at the same time. The central bank is making a commitment that it is not trying to drift. If the US has to taper QE, it has to prepare the market for that. Then it has to prepare the market for hikes and they have to hike, which all takes time.  

Shane, Morgan Stanley: But I think it has helped the real economy — don’t you think that’s fair?

O’Brien, Morgan Stanley: Yes, absolutely.

Shane, Morgan Stanley: People on the street, whether it’s small corporates, whether it’s individuals, believe that rates are going to be lower for longer. That’s got to be a healthy thing for driving growth.

Hill, RBC Capital Markets: We can debate how much difference this makes to the real economy or not, but another marker would be that all sub-2016 Gilts still yield below the Bank’s base rate.  

That would not be the case if the Bank had said nothing about its intentions for the path of interest rates into the future.  

So while in absolute terms total returns on short dated Gilts have been negative, on a rolling quarterly basis of late the differential between those negative returns and the negative returns you see on 10-15 year Gilts has been far more extreme. Investors have been far more sheltered by being in the sub-five year sector than in the 10-15 year sector than you would normally expect during a sell off by quite some way. That’s a sign that guidance on the forward path of rates has had some effect, even if it’s been underwhelming in absolute terms.

EUROWEEK: Has the possibility of rising rates sparked demand for floating rate paper in the UK as it has in the dollar market?

Stheeman, DMO: We do hear of occasional interest in the product, but it’s always worth reiterating, we are a fixed rate borrower. You could argue that a proxy for floating rate issuance is our Treasury bill stock, but that, while relatively small, is growing.  

The US has expressed a growing interest in FRNs as a product but that says perhaps more about the structure and profile of its overall debt portfolio in terms of the average maturity.

Our Treasury bill stock will be up to £70m by the end of the financial year. So the need for us to term out that floating form of debt is probably less than you find elsewhere.

Also offering an attractive enough spread in the FRN market is tricky. In some of the shorter maturities especially, we would probably be somewhere well below Libor, which would probably shut out quite a large part of the potential investor base for the product.

At the same time, anyone who issues a floating rate note, as always, will have to find a reference to which to attach it and Libor ain’t what it used to be.

EUROWEEK: Which is probably a good thing.

O’Brien, Morgan Stanley: Will you be watching US FRN issuance though?

Stheeman, DMO: Yes, absolutely. It’s interesting to see how they’re doing in terms of reference. But the driver towards the USA’s issuance of floating rate notes is fundamentally to do with the average maturity of their debt, which is a little over five years. Ours is a little under 15 years so the impetus is a different one here.  

Also the investor interest is slightly different here. I don’t sense an overwhelming desire to buy UK floating rate note assets, notwithstanding the fact that we do seem also to be potentially entering into a rising rather than a falling rate environment.

Pearson, Lloyds Bank: Do you think that the prospect of a big increase in centrally cleared derivatives with central clearing houses requiring government collateral could see future participants requiring much larger pools of government debt that doesn’t carry much duration risk with it? And that could mean either that you see bigger demand for your Treasury bills or because it might just be easier to manage floating rate note products.

Stheeman, DMO: From the narrow perspective of the DMO, our job is to minimise the cost of borrowing rather than fix the market’s structural problems. That doesn’t mean that we don’t have a potential interest in it, but it will be interesting to see if the sort of scenario that you’ve just painted leads to specific demand for collateral, which would potentially translate into better financing costs for us at the other end. 

O’Brien, Morgan Stanley: How much are people asking syndicate desks for floating rate notes? 

Shane, Morgan Stanley: From a syndicate perspective it’s a slightly different discussion, because of course DMO syndications come traditionally at the long end of the curve.

O’Brien, Morgan Stanley: But what about from corporate issuers?

Shane, Morgan Stanley: The vast majority of FRN buyers are able to buy fixed rate notes on an asset swapped basis. So while we have seen an increasing trend in FRN issuance, a large majority of that is simply a shift of buyers who would have otherwise have bought fixed rate securities and asset swapped them, saving themselves paying the bid/offer in terms of executing the derivative. 

There are very few accounts that I can think of that have demand for floating rate instruments that are not in a position to buy an asset swapped fixed rate bond.

Parkinson, RBC Capital Markets: The pockets of potential demand for such instruments generally exist as an alternative to buying T-bills or short-dated conventional Gilts. The DMO would have to determine that there was a cost advantage to the tax payer to issuing in a different format.  

We would also have to consider the impact on the liquidity of the existing instruments too. 

Another issue that’s pertinent here is that the liquidity regime for banks has been somewhat eased over the last year, and arguably that reduces the potential demand for floating rate Gilts. Liquidity portfolios have been net sellers of Gilts rather than buyers.

Diebel, Lloyds Bank: The Gilt market is largely owned by two groups of people — the pension funds and life insurers, and central banks. 

The central banks’ only interest in floating rate debt is the T-bill market, otherwise they’re in the five to 10 year sector. Pension funds and life insurers want the ultra-long dated Gilts. 

The DMO is probably the most aggressive sovereign borrower globally in terms of the duration it will push into the street, so let the Federal Reserve do what it likes on the floating rates.

EUROWEEK: There were headlines recently about Lloyds Bank being sold off, and the government has a number of assets on its balance sheet which could bring a revenue windfall. Do you have to make contingencies for that in your borrowing plan, or will you worry about that when it happens?

Stheeman, DMO: Probably more of the latter. Revisions in our remit are not dependent on individual transactions such as the possible sale of Lloyds Bank. We try and accommodate any sudden intra-year changes to the financing requirements through our cash management operations.  

We place a lot of emphasis on trying to make sure that the Gilt programme, within reason, is protected unless there’s a very, very significant movement in government finances, which tend to be announced at fixed times — one being the Budget, the other being the Autumn Statement. So were something to happen then, and that’s at this stage pure speculation, it would be accommodated in our cash management operations as necessary.  

O’Brien, Morgan Stanley: We talked about QE and expectations. QE under Carney is probably a far different event than QE under King, and therefore the curve will probably look quite a lot different. I suspect we’ll see more buying at the front end of the curve.

Hill, RBC Capital Markets: The new policy regime has retained some flexibility. You can’t say that QE has been ruled out, because if you look at the wording of the forward guidance, it says that the MPC stands ready to undertake further asset purchases, if warranted, while the unemployment rate is above 7%. But then at the speech in Nottingham there was quite a clear emphasis on keeping short end rates lower.

QE announcements have often led to a bounce. You get a reduction in yields, and then that fades very quickly. 

It might not be very long at all before at least one member of the MPC starts to vote for QE again. There was that hint in the August minutes. 

If anything there is a case for a bias towards buying the shorter sector. Probably the five year part of the curve would be where you would see the most benefit.

Pearson, Lloyds Bank: Do you think it’s more likely that we are going to get QE than not, Sam? If King was unable to get MPC members to vote with him when the economy was weaker, it is unlikely that Carney will be able to get members to vote with him for more QE when the economy is stronger.

Hill, RBC Capital Markets: It’s not RBC’s forecast that there will be an extension of QE, and also I can’t see any evidence that Mark Carney is an enthusiastic advocate of QE in a way that King was.  

But he did say that if the quasi-tightening that’s implied by higher expectations for bank rates goes further, he will act.

Pearson, Lloyds Bank: At the same time he also said he was happy with higher long dated yields, because they tell us the economy is doing better, which is exactly what we’re all after.

Hill, RBC Capital Markets: Yes, but he made a distinction between under five year and over five year maturities.

Pearson, Lloyds Bank: Yes, he did.

O’Brien, Morgan Stanley: If they don’t think they’re going to raise rates until 2016, it’s possibly a little negligent to do nothing and hope that there will be a steady drift downwards. 

The call for more QE is not our base case, but it is a possibility. We do see QE under Carney being quite a bit different.

Diebel, Lloyds Bank: Using QE in the circumstances that we’re presented with would be futile and probably counterproductive. I do hope Carney carries through with his threats to intervene with a more effective solution to just QE.

It comes back to what’s driving Gilt yields. Yet he has no control over the number one data driver, which is the US. So to sit there and go and buy a whole bunch of additional Gilts, if the US data continues to improve, is just a waste of money.

That’s quite a risk to take at this point in time, particularly when you’re leaning into an improved set of macro data.

We may be in for a bit of a data fade into year-end, but nonetheless the picture is improving. It really wouldn’t make any sense now.  

O’Brien, Morgan Stanley: It seems that Gilts are the favourite short — particularly in the 10 year sector — among investors I have met with recently. The Bank is up against a few things. It could push yields up quite a bit.

Stheeman, DMO: It’s an interesting comment. I don’t know what yields are going to do, I never have, and I probably never will.

Just before I came here I printed off a graph which showed all the movements in the last three months in the yield curve and by far the largest has been in the 10 year sector as you say.

But one thing I have learnt over the years is that if there is a general view, which is widely held, it’s usually wrong. And that goes for my own view on the direction of yields as well.

EUROWEEK: What changes have there been in overseas interest in the Gilt market? Is the UK still seen as safe haven?

Shane, Morgan Stanley: Holdings of Gilts by overseas investors continues to increase at a steady rate. 

In 2007 overseas investors held about 31% of the Gilt stock. In the 2012 data, it’s 30%, so at first sight it looks virtually unchanged or slightly lower. But of course this hides the effect of the Bank of England’s Asset Purchase Finance process. The Bank owns nearly 30% of the Gilt stock, so once you’ve stripped that out, the amount of overseas investors is up at 42% of the publicly held stock of Gilts — it’s a considerable increase.

Part of the reason for this has been the view that sterling is a source of stability compared to concerns about the euro. 

But it is also generally a long term trend. We’ve seen foreign exchange reserves for central banks grow, and that cash is looking to find a home and to diversify not just away from US Treasuries, but the dollar as well. Sterling has been a net beneficiary of that.  

For now we’ve probably seen the increase pause. A lot of the central banks that are active in these markets are caught up in their own emerging market currency crises, which has stunted the growth of FX reserves.  

Syndication distribution statistics tend to show 90% domestic and only 10% foreign sales. But they don’t give you the full flavour because syndications tend to be at the long end of the curve but overseas demand is concentrated on the one to 10 year maturities.

Stheeman, DMO: When looking at the statistics that we’ve published, it really is also worth looking at the nominal figures. At the end of Q1 2013, 31.2% of the overall Gilt portfolio was held overseas, versus 30.7% a year previously. That doesn’t sound like a big change, but when you look at numbers such, it was £380bn at the end of Q1 2012 versus £432bn at the end of Q1 2013 — that is a pretty sizeable increase.  

We are often asked about this whole issue about being a safe haven. I went out of my way to sound cautious this time a year ago, and also in particular 18 months ago, at the height of the eurozone crisis. It is in the nature of any safe haven bid that it can and probably will be unwound, because at one point the assessments of the respective strength of sovereign issuers will change. 

But I would like to think that the Gilt market will continue to benefit from the participation of major overseas investors, because people have a positive view on the Gilt market or the currency.

Diebel, Lloyds Bank: There’s more to it. The size of the reserves that these central banks hold these days has made them asset managers rather than reserve managers because they will willingly buy instruments that are less than perfectly liquid — and liquidity was the original rationale behind asset purchases. 

The archetypal liquidity-focussed one here would be the Bank of Japan, where they have put everything in sub-three year US Treasuries — that’s $1.3tr of sub-three year paper. That’s about as liquid as you can get, but most reserve managers don’t behave that way these days. 

As a result there is no reason that the Gilt market along with other G10, non-euro and non-dollar markets will continue to see support, because it’s almost inevitable that as an asset manager you’re working to typical diversification principles.

Stheeman, DMO: That diversification aspect has played a huge role in terms of purchases of sterling assets, even long before the eurozone crisis, arguably actually since the creation of the eurozone, because a number of major European currencies began to disappear at that point.  

Hill, RBC Capital Markets: Safe haven demand has been most observable at a time when there’s been a crisis in Europe. If that is on the increase, then that’s also driving part of the improvement in confidence that we are seeing in the UK economy. It’s worth remembering that when the emergency Budget took place in 2010, the forecast was that this year the government cash requirement would be £65bn, but it was actually £113bn when it was announced in the Budget in March this year.  

If we do see a reduction in safe haven demand, there’s a good chance that will go hand in hand with a reduction in the cash requirement forecast in future years, so alongside the sensitivity of prices to a small reduction in safe haven demand, there will be a corresponding benefit in the reduction of Gilt supply. I’m sure that overseas investors will respond accordingly and that there will be demand because of the improvement story for the underlying fundamentals of the UK economy.

O’Brien, Morgan Stanley: Robert, you issued an ultra-short Gilt a few years ago. Would you consider doing so again? There is a lot of overseas central bank investment at the very front end. They like liquidity but the outstandings are all old Gilts.

Stheeman, DMO: They are, although the way we have issued, and the way we usually issue Gilts is always that once it’s out there, we continue to re-open them, not just for the period that they might be specific benchmarks, but if necessary also at other times.  

Clearly the redemption profile is changing and we have to take that into account. So while the near term redemption profile used to be very small indeed, that’s no longer the case, so we’re pretty cautious about issuing ultra-short Gilts. But there will be times when we recognise, for instance, that there are particular market stresses and we might, if we felt it absolutely necessarily, and if there was sufficient demand, want to schedule ultra-short issuance via a mini tender if trading in a particular bond might have begun to look squeezy.  

Clearly the shape of the yield curve plays a role, we have a cost minimisation objective, so we have to look carefully at what is expensive and what is not. We try to balance that objective with our view on maturities and we feel that the overall reduction in refinancing risk, as a result of being able to issue as many longs as we do, is a desirable outcome, and we will probably focus on that. But I wouldn’t want to rule out that we would do something — that we would if necessary, address particular spots of illiquidity in the market.

Parkinson, RBC Capital Markets: RBC’s strengths are very much in the sterling and dollar block.

There have been a number of times during the euro crisis where we’ve seen waves of demand for Gilts, Canadian dollar bonds and Australian dollar bonds all at the same time at a particular maturity. So the safe haven flow is real, but the way we’ve always viewed it is as an intensification of demand, and that the net buying particularly of Gilts of up to 10 year maturities, over a longer period than the crisis, has been much more important than the periods of intensification.

EUROWEEK: Is the Gilt market a profitable primary dealership? Does Robert think it should be or not?

O’Brien, Morgan Stanley: One of the problems with the Gilt market is the liquidity that investors have is much better than the liquidity that dealers have themselves and the DMO is aware of that.  

However, to solve that problem, you require dealers to widen their bid/offer spreads which is unlikely in the foreseeable future

An electronic trading screen for GEMMs might be able to get round some of this.

Shane, Morgan Stanley: The days of arbitrarily spending money on primary dealerships is one for the history books but the Gilt market remains very competitive compared to other sovereign primary dealerships — there are probably not huge margins to be made.  

Banks are revenue and profit maximisers, and as a result of that, we look at market share and opportunities in light of a whole ream of ancillary benefits that may accrue from it. But the market still stands on its own legs, it’s not something that people are going to be committing huge costs to, just to achieve a market share objective because that just isn’t the environment we live in.

Parkinson, RBC Capital Markets: There are going to be ebbs and flows in profitability in any financial markets business, but I think all 18 institutional GEMMs hold their licences voluntarily. 

The important thing to remember is that a successful GEMM operation is typically part of a broader and well established fixed income business. RBC has been a GEMM since 2000. We’re one of the leading players in sterling credit and one of, if not the top player in the sterling SSA market over the last three or four years and we very much see the Gilt business as an integral part of that wider sterling fixed income business.

Pearson, Lloyds Bank: It’s a fair point. A GEMM isn’t a standalone business — in many institutions it’s servicing a variety of internal businesses, which in turn make their own profits. Historically that has driven aggressive and competitive pricing. Some of that’s deteriorating now as the regulatory environment is tougher, and capital charges higher.  

In addition, there’s uncertainty over the ring-fencing of investment banking from retail banking. At the moment, the significant market makers in the Gilt market are UK banks. The probability is that the Gilt market, as indeed all market making activities, will fall outside that ring-fence, resulting in a different operating environment that will impact the institutions involved in this activity.

Stheeman, DMO: Ralph asked the question whether we thought primary dealerships should be profitable. The easy answer is to say it’s not for us to determine that, but actually the honest answer is that we have always recognised the need for primary dealerships to be commercially viable for the GEMM community.  

We believe in the primary dealer system and we grant a number of privileges which go with being a primary dealer, the biggest of which is exclusive bidding rights at our auctions.  

We don’t, for instance such as in the US, have a facility for direct bidding — beyond a very small retail element — by the public, institutional or overseas investors. We give something which we hope is of value to the primary dealers. 

In return, we ask for certain obligations to be observed around minimum market share, but we are incredibly sensitive to applying rules around that that would make participation less commercially viable.  

That’s not because we’re nice guys — we’re not, I can assure you. It’s because we realise that the longer term health of the primary market relies on good commercial self-interest.

We are under no illusions about the benefit the government gets from our GEMMs taking down our supply in an orderly fashion and if necessary, using their balance sheets to warehouse the paper until it is passed on.

We recognise the need for the Gilt market to be a commercially attractive proposition over the long term for GEMMs. We’re very cautious about anything that might impact negatively on that commercial aspect, because we sure as hell can’t force people to buy our Gilts.

EUROWEEK: Would screen-based trading help?

Stheeman, DMO: It isn’t the role of the DMO to impose a particular model on the market. We follow these things very carefully and things that make the market transparent, in general we favour. 

But if you look at those instances where governments have tried to endorse specific electronic platforms, it’s not always been a uniquely happy experience. 

We don’t possess any absolute wisdom in terms of market structure, to say this is exactly the sort of market that we want, not least because the regulatory environment is constantly changing. What might have worked a few years ago, may not work now.  Obviously the same applies to the future. 

If this is the direction in which the whole market wants to move, and if it’s in keeping with the regulatory framework, we’re very happy to see that sort of thing happen. But it isn’t the job of the DMO to be the driving force behind that sort of thing.

Diebel, Lloyds Bank: Do you think that the progress towards greater regulation that is obviously coming down the pipeline poses a threat to liquidity in the Gilt market?

Stheeman, DMO: Conceivably, yes. It’s something which we are very focussed on and we engage very much with the Treasury on this as well. 

One of the positives about the UK set up is that actually we do have authorities who are very much attuned to the needs of the market. 

We are fortunate to have an extremely close and open dialogue with our colleagues in the Treasury on these sorts of things, because the law of unintended consequences, especially around some of the regulatory initiatives, seems to hold on a constant basis.  

We believe that a deep, liquid, well functioning Gilt market is absolutely crucial to us being able to fulfil our mandate.

EUROWEEK: Robert, you’ve said before that there are banks waiting in the wings to take over GEMM status and, as DMOs go, you’re especially close to your investor base. In fact you were able this year to mandate a firm for a syndication that has closed its SSA business and the deal still flew out the door. Is there an argument for paying lower or no syndication fees? After all, you have already told us you’re not a nice guy.

Shane, Morgan Stanley: I suspect you’re referring to UBS, and obviously there have been some changes there. But I suspect that Robert would still argue that they have a Gilt franchise and a significant presence in the market, and therefore they were able to perform the services of a syndicate manager perfectly capably.  

Other changes that might have taken place in their broader SSA franchise don’t reflect necessarily the bank’s capabilities in the Gilt market. Is that fair?

Stheeman, DMO: That’s absolutely fair. It’s not for us to pass judgement on the business model chosen by an individual GEMM. It’s much more important to see that the minimum standards that we require of GEMMs, and they’re not onerous, are observed.  

As to the question of syndication fees, I trust you’ve checked the exits of this room. I would argue — and funnily enough, I imagine I would get a lot of agreement from around the table at this point — that we don’t pay much in the way of fees in any case. 

But it’s worth asking what we are actually paying fees for. It’s not just hiring a selling group. We are paying fees because the whole process of de-risking our issuance is such that on balance, in our view, it makes sense in terms of not just our ability to sell, but for the wider market infrastructure, for us to be able to support something that allows us to deliver our programme. That’s a very important point, and we mustn’t lose sight of it.

Another thing we mustn’t lose sight of is that the alternative is the situation where we had much less to borrow before 2009/10, when we didn’t syndicate and we auctioned everything. One should not be under any illusion that the auction process is a costless process of issuance. The market can demand an auction concession, which could potentially be considerably in excess of any fees paid on a syndication. 

The sort of fees we pay in terms of a running cost, especially on our long-dated syndications are less than half a basis point — and sometimes a quarter of a basis point, of the nominal value. These are relatively small amounts in percentage terms. You just need, on the day of an auction, a 2bp market concession built in, which happens quite easily, and we would easily be paying multiples of that.  

The big difference of course is that one is an implicit cost and the other is an explicit cost, so one feels the need to justify it. But to me, I would like to think and hope that the involvement by the GEMMs in our market is not just based on fees that we pay out for syndications. It’s based on the notion that overall involvement has some commercial attraction.

O’Brien, Morgan Stanley: I think syndications have turned from just being a way to shift stock to being major liquidity events, especially for LDI buyers. That would not happen with auctions alone.  

Shane, Morgan Stanley: And that’s of great value to the health of the overall market.

Diebel, Lloyds Bank: You may carry out 90% of your issuing activities through regular auctions, but you never know when you need insurance. To introduce something like a syndication when you have never done them before is much more problematic than it is managing one as part of a regular programme that is fully supported by the financial community.

O’Brien, Morgan Stanley: It removes the worry of having a failed auction, which can damage an issuer’s credibility.

Parkinson, RBC Capital Markets: Syndications have become a market event, but GEMMs play an active role in translating generic demand from investors for a sector of the Gilt market into specific demand for the bond that’s for sale.

Stheeman, DMO: They happen throughout the dialogue which all the GEMMs and investors have with us, and in particular, the closer you get to a transaction, the discussions the lead managers will have with the investor base.

It is an iterative process. We learn from that dialogue because we will speak to the GEMMs and the lead managers. The information that we gather, as a result of the whole process, is vastly in excess of what we would gather just through the auction process alone.

Our knowledge of the market over the last four years now as a result of the syndication programme has increased hugely. The quantity and quality of the dialogue with the investor base has increased. That’s ultimately to the benefit of the Treasury and to the Exchequer as well.  

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