Government Business

The UK Debt Management Office (DMO), an Executive Agency of HM Treasury, is HM Government’s debt and cash manager. Its most high profile role is to finance the Government’s annual cash requirements through the sale of Government securities (gilts) to the market. Over the past few years the scale of this responsibility has grown considerably and planned gilt sales have risen to a record £62.5 billion in 2006-07.  On the basis of current projections for public finances, sales are set to continue at high levels for several years.
    
During this active period, the DMO has introduced a number of innovations both in the gilt market and in local authorities. These have been designed to ensure that government debt management maintains its standards of excellence in a constantly evolving environment. This article reviews these changes.

History and reasoning behind the DMO
Prior to April 1998, the Bank of England had acted as the Government’s debt manager. There are two major variables which determine the scale of the task of the Government’s debt manager.
    
The first, and most difficult to predict, is the Central Government Net Cash Requirement (CGNCR), which is essentially the difference between central Government’s income and expenditure in a given financial year in cash terms. The second is the redemption of maturing gilts.  These are the cash amounts that must be repaid to investors each financial year as gilts redeem.
    
The CGNCR typically fluctuates with the economic cycle and Government spending policy, as can be seen from chart 2. It was negative in the early years of the DMO’s existence but has turned positive in past years. On the other hand, gilt redemptions have been relatively stable, in a range of £15-20 billion per year since the creation of the DMO. In 2006-07, however, the forecast redemption total has increased significantly to £29.9 billion (a similar total is expected for 2007-08).
    
The combination of these two factors has underpinned the steady rise in planned gilt sales over the past few years.

“Ultra-long” gilt issuance
One of the more consistent themes in the gilt market has been the demand from pension funds and insurance companies for long-dated gilts (as high-quality assets to match their equally long-dated liabilities). Pension funds and insurance companies are, by some distance, the largest holders of gilts. Table 2 shows the distribution of gilt holdings at the end of June 2006, as published by ONS.
    
As part of its constant efforts to gauge the size and nature of demand for gilts going forward, in the summer of 2004 the DMO undertook an informal consultation with investors (fund managers), pension fund trustees, consultants, actuaries and academics. This was designed to assess demand specifically for long-dated gilts, including at maturities longer than the longest-dated gilts being issued at the time. The feedback received also confirmed that there was indeed interest in the Government issuing such significantly longer (up to 40 or even 50 years) maturity gilts in both nominal and index-linked formats.
    
The DMO and HM Treasury saw potential benefits for the Government in issuing ultra-long gilts. The inverted shape of the yield curve 1  made such instruments potentially attractive to issue on cost saving grounds. In particular, it was considered likely that investors might be willing to give up a premium to the Government in return for issuance of instruments that are valuable to them, but are in short supply (scarcity premium). Ultra-long gilts can be valuable to investors in the pension industry because it allows them to match their similarly very long-dated liabilities.

Following a formal consultation in December 2004 – January 2005, which  confirmed an earlier assessment by the DMO that it would be possible to issue ultra-long gilts at a favourable cost, HM Government initiated 50-year conventional gilt issuance on 26 May 2005 with the auction of 4.25 per cent Treasury Gilt 2055. This was the first such gilt since 1960, but its issue reflected a longer precedent of ultra long, and indeed undated, bond issuance by HM Government, over the past centuries. 4.25 per cent Treasury Gilt 2055 has now been auctioned six times and is currently over £11.5 billion (nominal) in issue. The 50-year index-linked gilt followed in September 2005, which now has £4 billion (nominal) in issue.

Index-linked gilts and syndication
On the index-linked front, the launch of 1.25 per cent Index-linked Gilt 2055 on 22 September 2005 provided the background for more innovation. It was, and remains, the longest-dated sovereign index-linked bond in the world. In addition, it was the first index-linked gilt to adopt a shortened indexation lag (three-month as opposed to an eight-month lag, which had been used hitherto). This technical modification improved the inflation protection provided by the bond to holders and brought the gilt market into line with current international best practice on index-linked bond design. All new index-linked gilts issued since have adopted the three-month lag.
    
Also innovative was the decision to use syndication as opposed to the traditional auction method to launch the 50-year index-linked gilt. This decision reflected a pragmatic approach in the context of an ambitious and innovative policy. When opening a new sector of the sterling market, where few points of comparison existed for pricing purposes, the DMO and HM Treasury considered that syndication was the appropriate issuance method on that occasion, as the dialogue that took place during the transaction between the DMO, banks and investors allowed a fair, efficient and transparent initial pricing process. The transaction was a major success, and the DMO subsequently re-opened this bond several times via auctions, as for any other gilt.
    
Overall, the DMO is planning to supply a record amount of long-dated as well as index-linked issuance in the current financial year. Together long nominal and index-linked issuance is likely to account for almost 70 per cent of total issuance in 2006-07. The DMO is committed to monthly, long index-linked issuance and is also planning this year to issue long-dated nominal gilts in every single month apart from August, when the market is less active. The DMO has also taken steps to increase further the transparency and predictability of issuance, for instance with a commitment to build up 5- and 10-year conventional benchmark gilts over the year.

Recent developments in the gilt market and remit flexibility
The DMO’s financing remit for 2006-07 provided further examples of how a robust, transparent policy framework combines with a pragmatic implementation. Towards the end of 2005, and in early 2006, a surge of demand for long gilts drove yields to historically low levels and triggered comments by stakeholders that the DMO should have greater flexibility to respond to substantial changes in market conditions and in the pattern of demand for gilts throughout the year.
    
The assessment conducted by the DMO and HMT led to the conclusion that temporary modifications could be introduced in the financing remit from HM Treasury which could both enhance the predictability and transparency of the current framework and increase the Government’s ability to respond to any substantial changes in market conditions.
    
The DMO financing remit for 2006-07, therefore included temporary modifications to the remit and included the introduction of a core gilt issuance programme of £53.0 billion and a supplementary issuance programme initially set at £10.0 billion (to be allocated on a quarterly basis throughout the year in a broadly even-flow manner i.e., £2.5 billion per quarter). Expectations were that supplementary issuance would be directed at long and index-linked issuance if market conditions remained similar to that prevailing at the time of the Budget. As this has remained the case (the yield curve for instance remains strongly inverted) supplementary issuance has been allocated predominantly to long conventional and some index-linked gilts – see table 3.  

50-year loans to local authorities
On the other side of the Government's balance sheet, HM Government has also increased the maturity of the loans it extends to local authorities through the Public Works Loan Board (PWLB). PWLB is a separate body, which operates within DMO, and lends funds to local authorities on demand. Its loans are sourced from the National Loans Fund (which is the pool into which receipts from gilts issuance are paid) and at rates only marginally higher than the Government’s own borrowing costs. PWLB rates are set according to prices in the secondary market for gilts. As HM Government initiated ultra-long borrowing, it was decided to give local authorities access to the benefits of this extension in the form of their being able to borrow from PWLB for maturities up to 50 years, where the limit had previously been 30 years.
    
This improvement came at an opportune moment for local authorities, which since the introduction of the 'prudential' system of self-regulation in April 2004 have enjoyed increased freedom to borrow. A combination of this increased financial flexibility and the availability of ultra-long loans led to a marked increase in borrowing. Gross PWLB advances last year were 50 per cent up on advances in 2004-05.

For more information  
For further details of the DMO and its operations visit the website www.dmo.gov.uk
 1i.e a downward sloping curve, where yields on longer-dated bonds are lower than those of shorter and medium bonds. The yield curve has been inverted for virtually all of the last seven years.