ÜBER-GILTS: CUI BONO?

Co-authored by Maria Nazarova-Doyle, investment consultant at Bluefin 

Setting the scene

The United Kingdom Debt Management Office, spurred by the UK Government, has published a formal consultation document to assess the market’s opinion on the proposed issuance of super-long and perpetual Gilts. Super-long Gilts are those with maturities in excess of 50 years, potentially significantly so. Perpetual Gilts have no fixed maturity.

Investigating the motive

We thought it would be a good idea to find out who will benefit from such a proposal.

Issuance of super-long bonds tends to be highly correlated with macroeconomic conditions and fluctuations in long-term interest rates. The supply of such bonds usually increases after declines in nominal and real interest rates. If the borrower believes that yields and inflation have hit bottom, then issuing super-longs makes perfect sense from a macroeconomic perspective. Considering that the current level of Gilt yields is at an all-time low, the Government would benefit from locking in these record low rates.

From the default risk perspective, there can only be an overall positive implication for the issuer if the super-long bonds are used to replace excessive short term debt, thus reducing the interest rate rollover risk.

Another advantage for the issuer is that the repayment of the principal is very far out in the future or not even necessary, as is the case for perpetuals.

All of the above should theoretically make the Government highly keen on selling super-long bonds. However, as the amount of super-long Gilts to be issued would be relatively small compared with the total value of outstanding Gilts, the positive effect on the Government’s finances would be very limited.

So if it is not the borrower who benefits the most, maybe it is the lender?

It has been consistently argued that the main ‘consumers’ of long-dated and perpetual Gilts are defined benefit (DB) pension schemes. A quick look at the DB universe shows that such schemes are predominantly closed to new entrants and/or future accruals and that the average duration of their liabilities lies in the region of 20 to 25 years. This implies that super-long Gilts would have maturities that are too long for most schemes.

Bearing in mind the fact that the PPF have successfully virtually eliminated their exposure to interest rates using maturities that are currently available, there is little need for super-long Gilts to effectively hedge out the interest rate risk. Matching specific cash flows would, in most cases, be very cost inefficient and, therefore, we anticipate that the current range of existing maturities would be more than sufficient to cover the hedging needs of more or less all schemes.
 
Another negative implication for potential demand for such Gilts would be the fact that many schemes are currently refraining from hedging, unwilling to subject themselves to extremely low returns and hoping that the yields will ‘mean revert’. This means that at the current low yields these schemes will not buy the ultralongs, but should the returns improve, the Government will lose the incentive to sell them.

Evidently, the potential benefits for both the UK Government and DB pension schemes are at best uncertain. Perhaps there is another interested party here that we have overlooked? Is there a potential investor out there that could reap über-rewards through buying the ultra-longs?

A lesson from the past tells us a story of woe for those who participated in the 1932 War Loans: every £100 invested in those loans would be worth, in real terms, around £1.75 today. This suggests that demand for nominal Gilts should be very low over the longer term as the risk of inflation over this period is just too great. Due to the shape of the yield curve beyond 30 years, it seems that potential investors would take on very much duration risk for very little extra yield. Therefore, the demand from non-hedging investors would be virtually zero as the compensation for the risk they would assume will not be provided by the current yield. Furthermore, the perpetuals are excluded from most index-tracking portfolios, which ought to reduce demand for such instruments even more.

Mystery solved?

After a thorough search of the UK market, we are still not close to finding out ‘whodunit’ – or, more precisely, who will be the biggest beneficiary if the super-long Gilts are issued.

It is not the Government: such super-longs would have no significant impact on the Government’s borrowing cost.

It is definitely not the pension schemes: the range of maturities currently available is more than sufficient to implement even very sophisticated hedging strategies. The schemes could potentially be interested in some index-linked Gilts with maturities of 60-70 years, but the demand is likely to be quickly saturated.

And for the non-hedging investors it certainly does not seem rational to buy these bonds. Not even for wealth preservation purposes.

Perhaps it might be considered that it is the Chancellor of the Exchequer himself, who would forever remain in the annals as the father of the ‘Osborne bonds.’
 

[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice. Click here for full disclaimer]