17 United Kingdom1
- International Monetary Fund
- Published Date:
- August 2003
Developing a Sound Governance and Institutional Framework
Objectives of debt management policy
The government’s current debt management policy was first outlined in the Report of the Debt Management Review in 1995. The debt management policy objective is: “to minimize over the long term the cost of meeting the government’s financing needs, taking into account risk, whilst ensuring that debt management is consistent with the objectives of monetary policy.”
This policy objective is achieved by
- pursuing an issuance policy that is open, predictable, and transparent;
- issuing conventional gilts that achieve a benchmark premium;
- adjusting the maturity and nature of the government debt portfolio by means of the maturity and composition of debt issuance and other market operations, including switch auctions, conversion offers, and buybacks;
- developing a liquid and efficient gilts market; and
- offering cost-effective retail savings instruments through national savings.
Before the 1995 review, the formal objective for debt management was to
- support and complement monetary policy;
- subject to this, avoid distorting financial markets; and
- subject to this, fund at least cost and risk.
However, it was felt these objectives were not an appropriate description of the way that debt management policy functioned in practice. In particular:
- Funding at least cost subject to risk is the primary objective of debt management policy.
- An efficient and liquid gilts market lowers yields and, hence, reduces funding costs, thus helping to achieve the primary objective.
- Debt management is not the major tool of monetary policy, nor is monetary policy the main objective of debt management.
- The objective did not mention the important specific roles of the gilts market and national savings.
The current objective focuses on the long term. This avoids the government seeking short-term gain by, say, reducing the debt interest bill over the published forecast period. The long-term nature of many of the instruments used in the debt market plus the importance of maintaining an issuer’s reputation mean that it is preferable to focus on long-term aims rather than seek short-run gains.
By taking account of risk, the government does not follow a purely cost-minimizing strategy. Rather, the government seeks to ensure that it is robust against a variety of economic results. The main way of doing this is by considering the effect of issuance on the ensuing government debt portfolio. Broadly speaking, the government will not be able to predict which particular gilt will prove to be cheaper than any other, because they will seldom be any better informed than the market on the future path of key macroeconomic variables. Indeed, the market will price any relevant information into the gilt yield curve. Therefore, it would seem futile for the government to attempt to beat the market systematically by trying to anticipate the future path of the economy that differs from that embodied in market expectations. It is therefore preferable for the government to select a portfolio that would protect it from as wide a range of economic shocks as possible.
In terms of operational delivery of the new debt management objective, the 1995 review heralded a move away from a highly discretionary debt management policy. The review rejected the thesis that discretion benefited the government in that it could sell appropriate debt at advantageous prices. It was felt that under such arrangements, the government would pay an unnecessary premium, because it would be systematically attempting to beat the market and there would be no certainty over or transparency in the path of issuance policy. Therefore, the review advocated a change to a policy that would promote a more efficient, liquid, and transparent market. It recommended a move toward a policy of annual published remits that would set out in advance issuance in terms of type and maturity of gilt, a preannounced auction calendar, and a movement toward more gilt sales by auction and less by tap.
Institutional framework for debt management
On May 6, 1997, the chancellor of the exchequer announced that he was granting operational control of interest rate policy to the Bank of England. Among the other changes announced were that operational responsibility for debt and cash management should pass to Her Majesty’s Treasury. Following a consultation exercise in July 1997, treasury ministers announced the creation of a new executive agency, the United Kingdom Debt Management Office (DMO), which would be charged with carrying out the government’s operations in the debt and cash markets. The DMO became officially operational as of April 1, 1998, and took over responsibility for debt management from the Bank of England from that date. Full responsibility for cash management was assumed on April 3, 2000.
Before April 1998, the Bank of England acted as the government’s agent in the debt and cash markets. The transfer to Her Majesty’s Treasury helped mitigate any perception that the government’s debt and cash operations might benefit from inside knowledge over the future path of interest rates and avoided a potential conflict of interest, or perception of conflict, between the objectives of the government’s debt and monetary policy operations. This separation of responsibilities allows the setting of clear and separate objectives for monetary policy, debt management, and cash management, with benefits in terms of reduced market uncertainty and, hence, lower financing rates. The Bank of England’s monetary policy committee is able to raise any issues about the implications of debt management for monetary policy with the treasury’s representative at monetary policy committee meetings.
As with all executive agencies, the DMO’s relationship with the treasury is outlined in a framework document.2 The basic structure for debt management is that treasury ministers advised by officials in the debt and reserves management team will set the policy framework within which the DMO will make operational decisions within the terms of the annual remit is set for them by treasury ministers. The DMO’s business objectives include a requirement for the DMO to advise the treasury about the appropriate policy framework, but strategic decisions rest with the respective ministers. The Bank of England acts as the DMO’s agent for gilt settlement and retains responsibility for gilts registration.
Legal framework for borrowing
The government’s overall policy on debt management is set out in “The Code for Fiscal Stability,” which has statutory effect by virtue of Section 155 of the Finance Act, 1998. Paragraph 12 of the code states that:
the primary objective of debt management policy shall be to minimize—over the long term—the costs of meeting the Government’s financing needs whilst:
- taking account of risk; and
- ensuring that policy does not conflict with monetary policy.
All central government borrowing is done through the treasury (including the DMO) or national savings, although the Bank of England acts as agent for foreign currency borrowing for the official reserves. National savings is responsible for providing personal savings products to members of the public (mainly small investors).
The treasury has wide discretion as to how to raise money by borrowing, and it does so through two statutory funds, the National Loans Fund and the debt management account. Its main power to borrow for the National Loans Fund is conferred by Section 12 of the National Loans Act, 1968, which was subsequently amended in 1998 to establish the debt management account. This provides that the treasury can raise any money that it considers expedient to raise for the purpose of promoting sound monetary conditions in the United Kingdom, and this money may be raised in such manner and on such terms and conditions as the treasury thinks fit. Section 12(3) of the same act makes it clear that the treasury’s power to raise money extends to raising money either within or outside the United Kingdom, and in other currencies. There are no set limits on the extent to which the treasury may borrow from outside the United Kingdom. The treasury’s power to borrow for the debt management account is conferred by Paragraph 4 of Schedule 5A of the National Loans Act, 1968, and this paragraph, like Section 12 of the act, gives the treasury a wide discretion as to how to raise money. Paragraph 4(3) is similar in terms to Section 12(3) of the act, and it provides that the treasury’s power to raise money under Paragraph 4 extends to raising money either within or outside the United Kingdom, and in other currencies. Again, there is nothing in Schedule 5 of the act to limit the amount of money the treasury may borrow from outside the United Kingdom.
In practice, treasury borrowing takes a wide range of forms and ranges from the issuing of long-term securities (gilts) to the issuing of short-term treasury bills (12 months maximum) under the Treasury Bills Act, 1877.
Organizational structure within the DMO3
The chancellor of the exchequer, under advice from treasury officials, determines the policy and financial framework within which the DMO operates and delegates to its chief executive operational decisions on debt and cash management and day-to-day management issues. The chief executive is appointed by the treasury and variously reports to the permanent secretary (on expenditure and related issues), treasury Ministers (on policy issues), and parliament (in the formal presentation of accounts). In particular, he/she is responsible to treasury ministers for the overall operation of the agency and delivering the remit (which may include a confidential element that expands on the published remit) in a way that he/she judges will involve the least long-run cost to the exchequer, subject to being compatible with other policy considerations.
The DMO is organized around eight business units (see Appendix) and has a structure of corporate governance in place to assist the chief executive in carrying out his responsibilities. This comprises a high-level advisory board, advising the managing committee, which is the senior decision-making body for the office. The managing committee is in turn supported by a credit and risk committee and strategy groups for each key business area (debt, cash, investments). There are currently two external nonexecutive directors on the advisory board, both of whom are also on the office’s audit committee, together with a member of the treasury. The advisory board, however, is an informal arrangement, and its proceedings are not published.
The DMO is an on-vote agency of the treasury, is financed as part of the treasury, and operates under arrangements that control its administrative cost. The DMO is subject to an internal audit function that reviews the systems of internal control, including financial controls, and to external audit by the national audit office. The chief executive is the accounting officer for both the office’s administrative accounts and the accounts of the debt management account, through which all its market transactions pass.
The chief executive of the DMO is responsible for setting the DMO’s personnel policies and managing staff. The office has delegated authority for pay, pay bargaining, training, and setting terms and conditions to recruit, retain, and motivate staff. Nonetheless, personnel policies are designed to be consistent with wider public sector pay policy and the Civil Service Management Code. The DMO achieved Investors in People accreditation in June 2000.
An important issue for debt managers is the need to control operational risk, which can entail large losses for the government and tarnish the reputation of debt managers. The DMO has developed a corporate governance framework to ensure sound risk monitoring and control practices to reduce operational risk (see the DMO’s functional structure in the Appendix). The “Statement on Internal Control” in the DMO’s Annual Report and Accounts (ARA) 2001-02 (available on the DMO’s web site) describes the DMO’s approach to managing its operational risk. A risk management unit has been established within the DMO. A business continuity plan is also being developed with key market participants to mitigate the impact of a severe disruption to the market’s infrastructure. The adequacy of the DMO’s management of risk and internal controls is regularly reviewed by the DMO’s audit committee, which is chaired by an external nonexecutive director.
Debt Management Strategy and the Risk Management Framework
Coordination of debt management and fiscal and monetary policy
The separation of debt management from monetary policy responsibility was part of the changes announced to the operation of monetary policy on May 6, 1997. However, the debt management objective still has a reference to monetary policy. It ensures that the Bank of England’s monetary policy responsibilities will not be undermined by the DMO or the treasury (e.g., “printing money” to meet the cash requirement or DMO cash market operations interfering with the Bank of England’s money market operations).4 This constraint on debt management reflects the institutional changes made in 1997. However, the Debt Management Review in 1995 noted that debt management no longer played a major role in the delivery of monetary policy objectives.5
The credibility of the United Kingdom’s fiscal policy is underpinned by the government’s fiscal framework6 that was introduced in 1997 as part of the macroeconomic reforms of the current administration. In addition, “The Code for Fiscal Stability” (1998) sets out the principles that guide the formulation and implementation of fiscal policy. The relationship between debt management and fiscal policy is an area where there is an ongoing program of work. The treasury will shortly be producing work that will look at the linkages between fiscal policy and the debt portfolio. This work includes the development of a comprehensive asset and liability risk monitor to aid the quantification of the risks faced by the central government on its balance sheet. A preliminary version was published in the Debt and Reserves Management Report 2002–03, as a precursor to the publication of the whole of government accounts in 2005–06. Other risks related to the central government’s contingent liabilities are currently being published annually within the “Supplementary Statements” that accompany the publication of the Consolidated Fund and National Loans Fund Accounts. A list of contingent liabilities and their maximum values is also available. Quantification and assessment of the risks that give rise to these liabilities will also be further developed.
Risk management framework
As previously noted, the 1995 Debt Management Review (as subsequently updated) established the primary objective of U.K. debt management policy as “to minimize over the long term the cost of meeting the government’s financing needs, taking account of risk, whilst ensuring that debt management policy is consistent with the objectives of monetary policy.” This primary objective has been reaffirmed in subsequent debt management reports, which are published annually with the budget papers. On the cost side, the main elements include nominal/cash-flow costs committed to when borrowing, real interest costs, accrual/net present value costs that include changes in capital costs on redemption, and the cost of issuance, which is relatively small for sovereign issuers.
These costs expose the balance sheet of the government to various risks, which are not as tractable as those of the private sector because governments tend not to match their financial liabilities with financial assets. Risks therefore need to be placed in the context of the overall government balance sheet and include
- default risk: the risk that the government will be unable to meet its nominal cash-flow commitments for interest and redemption payments;
- refinancing risk: the risk that government will be unable to refinance its maturing borrowing through further borrowing (or in doing so, it is faced with a high cost of finance);
- cash-flow risk: the risk that interest rate shocks cause large fluctuations in the debt interest bill; and
- mark-to-market/ex post financing risk: the risk that the government will regret its choice of borrowing instrument after the event because of nominal and real interest rate shocks.
Given the longevity of the government’s balance sheet and the long maturity of its potential borrowings, these costs and risks need to be traded off over a relatively long time horizon. The optimal debt portfolio, comprising different types of securities and maturities, will depend primarily on which type of risk the fiscal authorities are trying to contain and their preferences over any cost implications of a risk mitigation strategy. The focus could be on either variations in the debt-servicing cost alone (cash-smoothing/cost- at-risk) or in government spending as a whole (tax-smoothing). If considering the latter, the relationship among different economic variables and their effect on the level of the government’s annual deficit (e.g., on government revenues and the returns on government assets) also needs to be considered.
Debt management strategy
The treasury, with the DMO, determines the desired structure of new issuance over the year ahead, taking into account the financing requirement and considerations of the various costs and risks. This accounting structure is outlined in the annual Debt and Reserves Management Report (DRMR) and is expressed in terms of the percentage of issuance across each class of gilt and overall financing to be raised through the issuance of treasury bills. In consultation with the treasury and market participants, the DMO makes further decisions about specific issuance instruments and timing during the year in line with the overall target. Significant changes in the public finances forecasts may lead to a revision in the remit. The Chancellor’s Pre-Budget Report (generally available in November) provides an opportunity to revise this structure, if necessary in light of revised treasury forecasts for the economy.
It is currently the policy of the U.K. government to issue debt across a variety of instruments. At 7.83 years (by end-December 2001), the average modified duration of the gilts portfolio is longer than most of its peers among Organization for Economic Cooperation and Development member governments. This partly reflects the desire to minimize refinancing and cash-flow risks inherent in the high postwar debt-to-GDP ratios. It also prevents government financing from having a major impact on liquidity conditions for monetary policy and latterly has been a response to the high institutional demand for long-maturity paper from U.K. pension funds. Along with a relatively smooth redemption profile, this helps to add additional certainty to projections of future debt-servicing costs. Long duration will also limit the effect of any negative supply-side shock on the government’s fiscal position.
By end-December 2001, 24.6 percent of the marketable debt portfolio was made up of index-linked gilts and treasury bills. In the event of a demand shock, this proportion should allow the changes in the debt-servicing cost relating to this particular part of the national debt to mitigate the resulting move in the government’s budget balance. Of this, index-linked gilts also provide protection against a “nominal” shock. U.K. governments have not used foreign currency debt to finance the domestic borrowing requirement in peacetime, reflecting the belief that foreign currency risk to the balance sheet was neither desirable nor cost effective.
U.K. issuance of foreign currency debt in recent years has been used to augment the foreign currency reserves rather than for domestic funding reasons. Issuing liabilities in the currency in which the United Kingdom wished to hold foreign currency assets allowed exchange rate exposures to be hedged. However, the development of the swaps market has meant that the currency the debt is issued in, and the currency in which assets are held, do not necessarily have to be the same. Value for money is the primary concern when deciding whether to fund the foreign currency reserves from debt issued in pounds sterling swapped into foreign currency, or from the issuance of foreign currency–denominated debt, with the comparison being made on a swapped basis.
The government is conducting further work on managing risk in the debt portfolio by determining the resilience of cost and tax-smoothing properties of different debt structures to a range of economic conditions and shocks. This should help to quantify a more optimal debt portfolio against which an issuance strategy and long-term performance could be assessed.
The treasury select committee’s report on debt and cash management7 recommended, “that the Treasury considers adopting a benchmark approach to debt management … [that] … would help produce a clear published assessment of the costs and risks faced by the DMO.” Responding to the committee, the government accepted that greater transparency in performance measurement would be desirable if it could be achieved without compromising other strategic debt management objectives, but expressed reservations about the extent to which this was possible. The DMO’s aim has not been developed into an all-embracing quantitative target, or set of benchmarks, for four reasons:
- Minimizing debt interest costs over a short period could encourage opportunistic behavior with potential damage to the long run-objective. (A nonopportunistic approach to debt management reduces the long-term risk premium priced into gilt yields.)
- It is not straightforward to decide the interest rate risk that the exchequer should take in its liability portfolio, given that it is not being matched against a portfolio of financial assets.
- Any benchmark is not independent of the DMO’s own actions, as monopoly supplier of U.K. government bonds, and so it could be altered to a degree by the DMO’s decisions.
- The DMO and the treasury do not want to be considered to be taking short-term views on interest rate changes, to maintain the separation of monetary policy decision making and debt and cash management.
The DMO does not seek to manage the debt portfolio actively to profit from expectations of movements in interest rates and exchange rates, which differ from implicit market prices. This would risk financial loss as well as potentially sending adverse signals to the markets and conflicting with monetary or fiscal policies or both. It would also add to market uncertainty.
However, a target duration for the portfolio is implicit in the financing structure agreed annually with the treasury, in that it sets out clear parameters within which the DMO must operate is.
Developing the markets for government securities
Since the comprehensive review of debt management in 1995, there have been a number of advances in issuance techniques, the range of debt instruments has been refined and expanded, and numerous structural changes to the debt markets have taken place. The overall aim of the reforms has been to help lower the cost of public financing over the long term, responding to both endogenous and exogenous factors that have influenced the U.K. debt market during the period. In recent years, these factors have included budget surpluses, the rapid rise of the U.K. corporate bond sector, institutional changes (particularly those relating to pension funds), increasing technological and other advancements (which have enhanced systems), market structures, and debt instruments around the world.
The process of reform has been continued by the DMO, whose published objectives include “to conduct its market operations, liaising as necessary with regulatory and other bodies, with a view to maintaining orderly and efficient markets and promoting a liquid market for gilts.” All the changes to the market have involved considerable consultation with market participants and other stakeholders to develop broad-based support and promote predictability.
Although the benefits are difficult to quantify, transparency and predictability should reduce the amount the government is charged for market uncertainty (the “supply uncertainty premium”). Predictability should also allow investors to plan and invest more efficiently (in the knowledge of when and in what maturity band supply will occur) and thus reduce the liquidity risk premium. This is particularly the case in the United Kingdom, where government debt constitutes a relatively significant proportion of fixed-income debt and opportunistic trading on the part of the government would have a significant influence on the market.
The government’s borrowing plans for the year ahead are announced before the start of each financial year in the DRMR published by the treasury alongside the budget, usually each March.8 The DRMR details the financing requirement, the forecast sales of gilts, their breakdown by maturity and instrument type, and the gilt auction calendar for the coming year, along with planned short-term debt sales, including treasury bills. An auction calendar is also issued at the end of each quarter by the DMO, which confirms auction dates for the coming quarter and states which gilts are to be issued on which date. Normally, eight calendar days before an auction, the amount of stock to be auctioned is announced (and if it is a new stock, the coupon). At this point, the stock is listed on the London Stock Exchange (LSE) and when-issued trading commences. (This is the forward trading of the stock to be sold at the auction. When-issued trades settle on the auction’s settlement date, and the process helps reveal price information in the run-up to the auction.)
Market makers and end-investor groups are consulted during the formulation of these plans (and also quarterly before the DMO announces specific auction stocks for the quarter ahead).
Gilts are now issued entirely by auction unless there are exceptional circumstances. The DMO retains the ability to buy back or issue gilts in smaller quantities (by tap) at short notice for market management reasons only. Buybacks can be done either bilaterally or by reverse auction. The DMO also undertakes a range of market management operations, which are essentially neutral in terms of government financing and include the conversion or switching between specified stocks and repurchase (repo) activities. A gilt repo involves one party selling gilts to a counter-party with an agreement to repurchase equivalent securities at an agreed price on an agreed date. In June 2000, the DMO introduced a nondiscretionary standing repo facility, whereby the DMO may temporarily create upon request a gilt for repo, for the purpose of managing actual or potential dislocations in the gilt repo market. Operational transparency is enhanced through close coordination with market participants and agreed announcement and publication requirements.9
Portfolio operations and instruments
The U.K. securities market incorporates a range of debt instruments, including treasury bills, conventional gilts, double-dated gilts, undated gilts, index-linked gilts, and gilt strips.10 The distribution of the portfolio and the main holders of gilts are detailed in the Tables II.17.1 and II.17.2 and Figure II.17.1.
Figure II.17.1Composition of Debt Stock
Source: DMO quarterly review (October–December 2001).
|Gilt portfolio summary statistics|
|Nominal value of the gilt portfolio (including inflation uplift)||£274.92 bn|
|Market value of the gilt portfolio||£302.76 bn|
|Weighted average market yields:|
|Portfolio average maturity||1.28 yrs|
|Portfolio average modified duration||1.83 yrs|
|Portfolio average convexity||1.35|
|Average amount outstanding of largest 20 gilts||£9.80 bn|
|End-Dec. 2001 £bn||Percentage|
|Insurance companies and pension funds||183.7||63|
|Banks and building societies||3.1||1|
|Other financial institutions||29.6||10|
|Public sector holdingsa||4.4||2|
Local authorities, public corporations, and charities. Net of central government holdings.
Local authorities, public corporations, and charities. Net of central government holdings.
The DMO took over full responsibility for exchequer cash management on April 3, 2000.11 The transfer of cash management to the DMO was delayed from the earliest possible date in October 1998 by technical, capacity, and administrative issues (including concerns over systems during the millennium period).
The DMO’s main strategic objective in carrying out its cash management role is to “offset, through its market operations, the expected cash flow into or out of the National Loans Fund (NLF),12 on every business day; and in a cost effective manner with due regard for credit risk management.”13 An important part of the DMO’s approach is to seek to ensure that its actions do not distort market or trading patterns and as such, in its bilateral dealings with the market, the DMO is a price taker. The DMO also has to take account of the operational requirements of the Bank of England for implementing its monetary policy objectives.
The DMO carries out its cash management objectives primarily through a combination of weekly treasury bill tenders conducted on a competitive bidding basis, bilateral operations with DMO counter-parties, and repo or reverse repo transactions.
Treasury bill tenders are currently held on the last business day of each week for settlement on the next working day. Following the final tender at the end of each calendar quarter, the DMO issues a notice broadly outlining the maturities of treasury bills available in each week of the next quarter. The precise quantities of bills on offer and the maturity of bills on offer in each week are announced one week before the relevant tender.
To facilitate a significant increase in the stock of treasury bills, the DMO changed the arrangements relating to the issuance by tender of treasury bills from October 5, 2001. As part of these changes, the DMO recognized a list of primary participants in the treasury bill market. These are banks or financial institutions that have agreed to place bids at treasury bill tenders on behalf of other parties, subject to their own due diligence and controls. On request, the primary participants will also provide their customers with secondary dealing levels for treasury bills. The DMO’s cash management counter-parties and a limited number of wholesale market participants who have established a telephone bidding relationship with the DMO are also eligible to bid directly in treasury bill tenders.
The DMO publishes the tender results on the wire services pages. The DMO will announce, at the same time, the amounts on offer at each maturity at the next tender, together with an outline of any planned ad hoc tenders to be held in the following week.
The DMO may also issue shorter-maturity treasury bills (up to 28 days) at ad hoc tenders. The objective of ad hoc tenders will be to provide additional flexibility for the DMO in smoothing the exchequer’s cash flows, which the regular tender program may not provide.
Conventional gilts are the simplest form of government bond and constituted 70.3 percent of the debt portfolio as of end-December 2001. There are eight undated gilts still in issue, making up about 1 percent of the portfolio. Their redemption is at the discretion of the government, but because of their age, they all have low coupons and there is little current incentive for the government to redeem them. The last floating-rate gilt (whose coupon was set with reference to the three-month Libid [London interbank bid]) rate] was redeemed on maturity in July 2001. To avoid periodic price fluctuations related to coupon payment dates, gilt prices are now quoted clean, that is, without accrued interest, although the “dirty” price (including accrued interest) is used for conversion offers.
The United Kingdom was one of the earliest governments to introduce index-linked bonds, with the first issue in 1981. Index-linked bonds now account for about 25 percent of the government securities portfolio.
The U.K. gilt STRIPS market was launched on December 8, 1997. “Stripping” a gilt refers to breaking it down into individual cash flows that can be traded separately as zero-coupon gilts. Not all gilts can be stripped, although it is the DMO’s intention to make all new gilts strippable. The STRIPS market was introduced to permit investors to
- closely match the cash flows of their assets (strips) to those of their liabilities (e.g., annuities),
- enable different types of investment risk to be taken, and
- bring the range of products offered in the U.K. market in line with other large markets, such as the United States, Japan, Germany, and France.
From the issuer’s perspective, a STRIPS market can result in slightly lower financing costs if the market is willing to pay a premium for “strippable” bonds. As of September 28, 2001, there were 11 strippable gilts in issue, totaling £115.18 billion (nominal). Of these, £2.4 billion of stock was held in stripped form. All issues have aligned coupon payment dates. This means that coupons from different strippable bonds are fungible when traded as strips. However, coupon and principal strips paid on the same day are not fungible, that is, a specific bond cannot be reconstituted by substituting the relevant principal strip with a coupon strip with the same maturity. This feature protects the overall size of any issue and thus maintains the integrity of various benchmarking indices.
The first series of strippable stocks were issued with June 7/December 7 coupon dates; however, in 2001, the DMO issued two new conventional stocks with coupon dates aligned on March 7/September 7. These stocks will become strippable from April 2002. The second series of coupon dates was introduced to avoid cash flows becoming too concentrated on just two days in the year.
Although anyone can trade or hold strips, only a gilt-edged market maker (GEMM), the DMO, or the Bank of England can strip (or reconstitute) a strip-pable gilt through the CREST electronic settlement system. GEMMs are obliged to make a market for strips.
The market in gilt strips has grown slowly since its inception. Factors that have contributed to this slow take-off have been the need for pension fund trustees to give appropriate authority to fund managers to invest in strips and the inversion of the yield curve over the period since the inception of strips, which makes strips appear expensive relative to conventional gilts. Retail demand for strips has also been hampered by the necessary tax treatment, whereby securities are taxed each year on their accrued capital gain or loss, even though no income payment has been made. However, the ability to hold strips within some tax-exempt savings products will reduce the tax disincentives to personal investment in strips.
The U.K. government bond market operates as a primary dealer system. As of end-December 2001, there were 16 firms recognized as primary dealers (GEMMs) by the DMO. Each GEMM must be a member of the LSE and must undertake a number of market-making obligations in return for certain benefits.
In broad terms, the obligations of a GEMM are to participate actively in the DMO’s gilt issuance program, make effective two-way prices on demand in all nonrump gilts and non-index-linked gilts, and provide information to the DMO on market conditions. As September 28, 2001, 10 of the 16 recognized GEMMs were also recognized as index-linked gilt-edged market makers (IG GEMMs). Their market-making obligations extend to cover index-linked gilts.
The benefits of GEMM status are exclusive rights to competitive telephone bidding at gilt auctions and taps, either for the GEMM’s own account or on behalf of clients; exclusive access to a noncompetitive bidding facility at outright auctions; the exclusive facility to trade or switch stocks from the DMO’s dealing screens; exclusive facilities to strip and reconstitute gilts; an invitation to a quarterly consultation meeting with the DMO15 (allowing the GEMMs to advise on the stock(s) to be scheduled for auction in the following quarter and discuss other market-related issues); and exclusive access to gilt interdealer broker (IDB) screens. In addition, any transactions undertaken by the DMO for market management purposes are carried out only with or through the GEMMs.
Since early 2002, the GEMMs have been required to provide firm two-way quotes to other GEMMs in a small set of benchmark gilts. These quotes are to be made on a near-continuous basis on any of the recognized IDB screens. The purpose of this new obligation is to enhance liquidity in the intra-GEMM market for the benefit of the entire secondary market for gilts.
As of end-December 2001, there were three specialist gilt IDBs operating in the gilt market. Their services are limited to the GEMM community. Their main purpose is to support liquidity in the secondary markets by enabling the GEMMs to unwind anonymously any unwanted gilt positions acquired in the course of their market-making activities. All but a few inter-GEMM trades are executed through an IDB. Non-index-linked GEMMs have no access to index-linked screens.
Each IDB is registered with the LSE and endorsed by the DMO. The DMO monitors this segment of the market on an ongoing basis to ensure that an IDB service is available to all GEMMs on an equitable basis and the market-maker structure is effectively supported by the IDB arrangements. The IDBs are also subject to specific conduct-of-business rules promulgated by the LSE. For example, they are prohibited from taking principal positions or from disseminating any market information beyond the GEMM community.
Mechanisms used to issue gilts
Auctions are the exclusive means by which the government issues gilts as part of its scheduled funding operations. However, the government retains the flexibility to tap or repo both index-linked and conventional gilts for market management reasons. The move to reliance on a preannounced auction schedule reflects the government’s commitment to transparency and predictability in gilt issuance.
The government uses two different auction formats to issue gilts:
- conventional gilts are issued through a multiple-price auction, and
- index-linked gilts are auctioned on a uniform-price basis.
The two different formats are used because of the different nature of the risks involved to the bidder for the different securities.
Conventional gilts are viewed as having less primary issuance risk. There are often similar gilts already in the market to allow ease of pricing (or, if more of an existing gilt is being issued, there is price information on the existing parent stock); auction positions can be hedged using gilt futures; and the secondary market is relatively liquid. This suggests that participation is not significantly deterred by bidders not knowing the rest of the market’s valuation of the gilts on offer. A multiple-price auction format also reduces the risk to the government of implicit collusion by strategic bidding at auctions.
In contrast, positions in index-linked gilts cannot be hedged as easily as conventional gilts. The secondary market for index-linked gilts is also not as liquid as for conventional gilts. Both of these factors increase the uncertainty of index-linked auctions and increase the “winner’s curse” for successful bidders—that is, the cost of bidding high when the rest of the market bids low. Uniform price auctions thus reduce this uncertainty for auction participants and encourage participation. In addition, there are fewer index-linked bonds than conventionals in issue, so pricing a new index-linked issue may be harder than for a new conventional.
GEMMs also have access to a noncompetitive bidding facility under both formats. They can submit a noncompetitive bid for up to 0.5 percent of the amount of stock on offer in a conventional gilt auction. The proportion of stock available to each index-linked GEMM in an index-linked auction is linked to their performance in the previous three auctions.
The DMO allots stock to individual bidders at its absolute discretion. In exceptional circumstances, the DMO may choose not to allot all the stock on offer, for example, where the auction was covered only at a level unacceptably below the prevailing market level. In addition, the DMO may decline to allot stock to an individual bidder if it appears that to do so would be likely to lead to a market distortion. As a guideline, successful bidders, either GEMMs or end-investors, should not expect to acquire at the auction for their own account more than 25 percent of the amount on offer (net of the GEMM’s short position in the when-issued market or parent stock or both) for conventional gilts and 40 percent for index-linked stock.
The DMO will use taps of both conventional and index-linked gilts only for market management reasons in extreme conditions of temporary excess demand in a particular stock or sector. The last tap was in August 1999.
Conversion offers and switch auctions
In addition, the DMO will occasionally issue stock through a conversion offer or a switch auction, in which stockholders are offered the opportunity to convert or switch their holding of one gilt into another at a rate of conversion related to the market prices of each stock. In both cases, the main purposes of these operations are to
- build up the size of new benchmark gilts more quickly than can be achieved through auctions alone (This is particularly important in a period of low issuance.); and
- concentrate liquidity across the gilt yield curve by reducing the number of small, high-coupon gilts and converting them into larger, current-coupon gilts of broadly similar maturity.
Conversion candidates will not have fewer than about five years to maturity or more than £5.5 billion nominal outstanding. In addition, conversion offers will not be made for a stock that is “cheapest-to-deliver,” or has a reasonable likelihood of becoming cheapest-to-deliver, for any gilt futures contracts with any outstanding open interest.
The price terms of any conversion offer will be decided by the DMO, using its own yield-curve model to provide a benchmark ratio for the offer. The DMO will then (at its own discretion) adjust this ratio to take some account of the observed cheap/dear characteristics of the source and destination stocks. Conversion offers remain open for a period of three weeks from the date of the initial announcement of the fixed dirty-price ratio. The appropriate amount of accrued interest on both gilts is incorporated into the calculation of the dirty-price ratio for forward settlement. The conversion itself will involve no exchange of cash flows.
Acceptance of such offers is voluntary, and stockholders are free to retain their existing stock. However, this is likely to become less liquid (i.e., traded less widely, with a possible adverse impact on price) if the bulk of the other holders of the gilt choose to convert their holdings. Should the amount outstanding of a gilt be too small to expect the existence of a two-way market, the DMO is prepared, when asked by a GEMM, to bid a price of its own choosing for the gilt. In addition, the DMO would relax market-making obligations of GEMMs in this “rump” gilt. The DMO would announce if a gilt took on this “rump” status.
In addition to the main purposes identified for conversion offers, switch auctions were introduced in 2000 to
- allow the DMO to smooth the immediate gilt redemption profile by offering switches out of large ultra-short issues into the current five-year benchmark (or other short-term instruments), and
- facilitate switching longer by index-tracking funds as a particular stock is about to fall out of a significant maturity bracket, thus contributing to market stability.
Switch auctions are held only for a proportion of a larger stock that is too large to be considered for an outright conversion offer. The DMO ensures that a sufficient amount of the source stock remains for a viable, liquid market to exist following a switch auction. Hence, the DMO will not hold a switch auction for a conventional stock that would reduce the amount in issue to below £4.5 billion (nominal). Switch auctions are held only when both the respective stocks are within the same maturity bracket, although here the maturity brackets overlap (short and ultra-short, 0–7 years; medium, 5–15 years; long, 14 years and more). In addition, the DMO will not hold a switch auction out of a stock that is cheapest-to-deliver, or has a reasonable likelihood of becoming cheapest-to-deliver, into any of the “active” gilt futures contracts. The DMO might, however, switch into such a stock.
Switch auctions are open to all holders of the source stock, although non-GEMMs must route their bid through a GEMM. They are conducted on a competitive bid-price basis, where successful competitive bidders are allotted stock at the prices they bid. There is no noncompetitive facility, and the DMO does not set a minimum price.
The same principles apply to index-linked switch auctions with the following exceptions. First, index-linked switches will be held only when both the respective stocks have longer than four and one-half years to maturity and when the source stock has not been auctioned in the previous six months. Second, the (nominal) size of any single index-linked switch auction is limited to £250 million to £750 million of the source stock, and the DMO will not hold a switch auction that would leave an index-linked stock with a resultant amount outstanding of less than a nominal £1.5 billion. Third, the auctions are conducted on a uniform bid-price basis, whereby all successful bidders will receive stock at the same price. Where a GEMM’s bids are above this price, it will be allotted in the full amount bid, but allotments for bids at the striking price may be scaled. Published results will include the common allotment price, the pro rata rate at this price, the real yield equivalent to that price and the inflation assumption used in that calculation, and the ratio of bids received to the amount on offer (the cover). Only one index-linked switch auction has been held up until end-2001.
The gilt repo market was introduced in January 1996. After 1986, a limited market in stock borrowing existed in which GEMMs (and discount houses for short-dated stocks) were allowed to cover short positions by borrowing stock in the stock-lending market and approved stock lenders were allowed to lend. However, the introduction of an entirely open trading market in gilt repos has enabled market participants to borrow or lend gilts more easily. This has improved market liquidity and the ease with which gilt positions can be financed. A Bank of England survey put the size of the gilt repo market as of November 2001 at £130 billion (equivalent to one-fourth of the pound sterling money market at that time), with an additional £48 billion of stock lending.
Gilt repos now account for the majority of Bank of England monetary policy operations and a significant proportion of the DMO’s dealing to manage the exchequer’s cash flow. It is estimated that gilt repos now account for about half of all overnight transactions in the pound sterling money market. Conduct in the gilt repo market is guided by the Gilt Repo Code of Best Practice, as published by the stock lending and repo committee chaired by the Bank of England (latest version, August 1998).
The DMO has the ability to create and repo specific stocks to market makers, or other DMO counter-party, under a special repo facility if, for example, a particular stock is in exceptionally short supply and distorting the orderly functioning of the market. In response to a previous consultation exercise, the DMO introduced, in June 2000, a nondiscretionary standing repo facility, for the purpose of managing actual or potential dislocations in the gilt repo market. Any registered GEMM, or other DMO counter-party, may request the temporary creation of any nonrump stock for repo purposes. The DMO charges an overnight penalty rate, and the returned stock is canceled.
Recent Factors Shaping the U.K. Bond Markets
As in other currencies, the pound sterling credit market has seen increased annual private issuance in recent times, at a time when the United Kingdom has been running a budget surplus. Thus, the government’s percentage of the overall outstanding pound sterling debt market had been steadily reducing. Decreasing government funding requirements have led to gilts acquiring a scarcity premium, especially in longer-dated stocks, which in turn has lead to a reduction in yields. At the same time, the United Kingdom has enjoyed a low-inflation, low-interest rate environment recently (relative to the 1970s and 1980s), so a need to enhance returns has led investors to increase their appetite for (credit) risk.
As the U.K. government’s budgetary position improved, gross issuance of gilts declined from a peak of £54.8 billion in financial year 1993–94, reaching a minimum of £8.1 billion in 1998–99. However, given that the government’s borrowing needs are cyclical, there is a benefit in maintaining a minimum level of issuance so that market infrastructure is sustained and the market remains sufficiently liquid and retains the capability to absorb future larger gross issuance. Table II.17.4 summarizes the government’s forecast for the central government net cash requirement over the next few years. The medium-term forecasts point to a prudent level of borrowing, reflecting planned investments in public services that are fully consistent with the fiscal rules.
|Market value of debt||£287 bn||£348 bn||£374 bn||£343 bn|
|Net debt/GDP (percent)||1.8||1.8||1.8||1.3|
|1–02 projection||1–03 projection||1–04 projection||1–05 projection||1–06 projection||1–07 projection|
In view of the limited amount of gilt issuance in recent years, the DMO has adopted a number of strategies to concentrate debt issuance into larger benchmark issues, currently at three maturity points, with a 5-, 10-, and 30- year term to maturity. These larger issues allow governments to capture a liquidity premium across the yield curve. The DMO has also used conversion and switch auctions to build up benchmark issues.
The government also decided to launch a structured gilt buyback program in fiscal year 2000/01 to add to gross issuance and thus help to maintain liquidity in the market during a time of strong demand. Following market consultations, reverse auctions were reintroduced in fiscal year 2000/01 while the DMO bought in, direct from the secondary market, short-dated index-linked gilts and double-dated gilts. The DMO also buys in near-maturity gilts (with less than six months’ residual maturity) as part of its regular operations to smooth the cash-flow impact of redemption.
In general, these operations have been very successful. There was more than 90 percent take-up of the conversion offers, apart from the one conducted in November 1998. The switch auctions have all been covered with a comfortable margin, and the three longer-dated switches have secured very attractive forward-dated funding rates. The rates at which the DMO has repurchased stock in the reverse auction was at yields, which were predominantly “cheap” relative to the DMO’s fitted yield curve.
During fiscal year 2000/01, the DMO (in consultation with the Bank of England, the treasury, the Radio Communications Agency, and market participants) put in place arrangements to facilitate the smooth handling of much larger than expected receipts from the third-generation mobile phone license auction. Total receipts of £22.5 billion amplified the fiscal surplus in fiscal year 2000/01. The government subsequently decided to maintain a minimum level of gross gilts issuance to sustain gilt market liquidity and investor interest in light of the forecasts of an increase in the financing requirement over the next few years. As a consequence of these policy decisions, the DMO held a short-term net cash position of £11 billion at the end of fiscal year 2001/02. Partly to assist the management of this, the range of high-quality, short-term money market instruments in which the DMO may transact on a bilateral basis for cash management purposes was extended in October 2000. It is expected that the cash position will be run down over the three financial years to end-March 2004.
As part of its continuing commitment to encourage liquidity and transparency of the gilts market, the DMO consulted widely in 2000 about the possible impact of electronic trading systems on the secondary market for gilts and how the DMO’s relationship with the GEMMs might change as a consequence. That work continued during 2001, with a view to introducing early in 2002 inter-GEMM mandatory quote obligations in the more liquid gilts, as outlined in the response document published in June 2000.
To promote further transparency in the gilts market, in September 2000, the DMO introduced a real-time benchmark gilt price screen on its wire services showing indicative midprices for a series of gilts derived from GEMMs’ published quotes.
In 1995–96, the basis for taxation of gilts was reformed. Essentially, this meant that capital gains or losses on gilts experienced by corporate investors would be taxed similarly to income from gilts. This eliminated most of the tax-driven pricing anomalies in the market by making the tax system neutral with regard to holding high- or low-coupon bonds, which was a necessary precondition to launching the STRIPS market to avoid tax-based incentives for stripping all or none of a bond. In addition, since April 1998, all gilt interest has been paid gross, unless the recipient has preferred net, to reduce the compliance obligations for custodians and make the gilt market more accessible and attractive to investors.
The case study was prepared by the U.K. Debt Management Office and the Debt and Reserves Management Team of the U.K. Treasury.
A full description of all the DMO’s responsibilities, objectives, and lines of accountability is set out in the current version of its Framework Document (July 2001, www.dmo.gov.uk/publication/f2spc.htm). Other relevant documents can be found on the DMO’s web site: www.dmo.gov.uk.
The following information reflects the situation as of June 30, 2002. However, effective July 1, 2002, the DMO took on two additional business units: the public works loans board and the commissioners for the reduction of the national debt. This led to an increase in the number of staff at the DMO to about 80 employees. Before July 1, 2002, another government department—the national investment and loans office—had carried out the functions of the public works loans board and commissioners for the reduction of the national debt. The staff were transferred from the national investment and loans office, which no longer exists.
The DMO Handbook: Exchequer Cash Management in the United Kingdom (February 2002) details the interaction of cash management with U.K. monetary policy and can be found on the DMO’s web site.
Further detailed discussion can be found in K.Alec Chrystal, ed., Government Debt Structure and Monetary Conditions (London: Bank of England), 1999.
A detailed discussion of the fiscal framework can be found in HM Treasury, Analysing U.K. Fiscal Policy, 1999, available at www.hm-treasury.gov.uk/mediastore/otherfiles/90.pdf. A full discussion of recent developments in macroeconomic and financial policy can be found in HM Treasury, Reforming Britain’s Economic and Financial Policy—Toward Greater Economic Stability, 2001, available at www.palgrave.com/catalogue/catalogue.asp?Title_Id=0333966104.
“Government’s Cash and Debt Management” (HC 154) (available at www.publications.parliament.uk/pa/cm199900/cmselect/cmtreasy/154/15402.htm) was published on May 22, 2000. It provides a comprehensive guide to the government’s cash and debt management arrangements as well as records of the oral evidence provided by officials and expert witnesses.
The Debt Management Report was first published in 1995–96. It was retitled the Debt and Reserves Management Report in 2001–02, when it outlined for the first time the annual framework for the management of official foreign currency reserves.
Full details of all these instruments and operations are available in the “Gilt Operational Notice” and “Cash Operational Notice” on the DMO web site.
Full details of all these instruments and operations are available in the “Gilt Operational Notice” and “Cash Operational Notice” on the DMO web site.
The DMO Handbook: Exchequer Cash Management in the United Kingdom (February 2002) details the cash management operations and can be found on the DMO’s web site.
The National Loans Fund is the account that consolidates all government lending and borrowing.
The strategic objective for cash management is contained in a remit “Exchequer Cash Management Remit,” published in HM Treasury, Debt and Reserve Management Report 2002–03 (London), March 2002.
A full description of the separate trading of registered interest and principal of securities (STRIPS) market is given in the information memorandum, “Issue, Stripping and Reconstitution of British Government Stock,” July 2000, on the DMO web site.
The DMO also holds quarterly meetings with the representatives of end-investors. Minutes of these meetings are published shortly afterwards on the DMO’s web site. In addition, there are annual meetings with the economic secretary to the treasury for both groups in January as part of the preparations for the annual remit, published in March.