TRANSCRIPT: Interview with UK DMO CEO Sir Robert Stheeman on 27 July 2021
9 August 2021
By David Barwick – FRANKFURT (Econostream) – Following is the full transcript of the interview conducted by Econostream on July 27 with Sir Robert Stheeman, Chief Executive Officer of the UK Debt Management Office:
Q: How big a problem for you are inflated syndication orders, and what if anything do you think needs doing about it?
A: I would start off by saying that this is clearly a very topical question. It’s much easier to identify the issue than it is to provide a solution The fact that syndications have become such a widely used tool, and that their design and operation is now so standardised, suggests that in the market there’s a high degree of consensus as to how they should work. But there’s not necessarily a high degree of consensus as to how to deal with unrealistic order books. We have ourselves, like everyone else, recently observed order books for syndications are typically much larger – not just a little, but much larger – than the planned size of the transaction. We are not alone - that applies to numerous other sovereign debt managers. Interestingly, the number of investor accounts participating in our syndications has also grown, and the obvious reason is that as opposed to an auction, in which the published statistics are entirely driven by supply-demand price factors, in a syndication, the pricing is not necessarily directly correlated with the size of the order book. And that is an important point. Clearly, investors who want to have a high degree of certainty around a minimum allocation of bonds have started to bid for larger amounts than they would realistically expect to receive. And that additional bidding can be sizeable. But it is also misleading in terms of the overall underlying demand that currently exists for an issue. So I would argue strongly - and I’ve argued this in writing to our Treasury Select Committee - that one should not be misled by the size of the order book as an indication of what true end-investor demand is. So it’s not that this behaviour is necessarily obviously wrong, but the actual informational value of the order book statistics is in fact quite limited, and we would not want any outside observer to draw the wrong conclusions about any particular transaction and how it’s going. So from our perspective, what can you do about it? That’s where it probably gets a little bit more interesting. We take the view that we as issuer are not directly responsible for the allocation process. As far as I’m concerned, the thing that is probably the most effective tool in actually minimising the size of the order book is to make sure that the indicative price guidance – which has to be agreed between ourselves as issuer and the lead manager group – is at the time of launch, barring any unforeseen event, as closely as possible reflective of where we and the lead managers judge that issue will end up achieving a fair price, and one where it will trade in the market once it becomes a tradeable instrument. And we ourselves at the DMO go to a lot of effort to analyse the market very closely. I would like to think actually we do this probably not just more than most other sovereign borrowers, but to a finer degree. Some sovereign borrowers routinely show what’s known as indicative price spreads that could be anything between two, three, five basis points as an indication. If possible, we try to make sure that the indicative price spread that is announced ahead of books opening on the transaction has a very narrow range, preferably less than one basis point. That doesn’t completely discourage or eliminate inflated orders. What it does do is set market expectations as to the likely price spread very clearly. We also – and this is important - indicate to our chosen lead managers, who are always responsible for the allocations, that we expect them as a general rule to make allocations that are supportive of both the transaction and our core investor base. Most of our syndications are actually designed with those core investors in mind and it is our hope that they will be favoured regardless of the size of the orders. So-called real money investors as a rule tend to place orders that are realistic in size. We expect our lead managers to be able to discern very clearly between an inflated order and an order that is more obviously sensibly sized from a buy-and-hold investor. Is that all a perfect solution? No. My guess, however, is that in the future, we will see in international capital markets the whole syndication process evolve, perhaps be further refined. Investor behaviours may also change as market liquidity conditions change, and you may see a reduction eventually in the size of order books. It’s just important that we as a borrower know our market well enough so that we know what’s going on and make the correct judgements. And that can inform any decisions we have to make on pricing.
Q: What modifications to 2021 funding needs do you expect between now and the end of the year?
A: No date has yet been set for the autumn fiscal event, and while the public finance data that were published on July 21 showed that cumulative government borrowing for the first three months of this year was running some £19 billion below the forecast by the OBR in March, it’s nonetheless premature for me to speculate now on how the public finances might develop in the period ahead or what conclusions the OBR might reach and what those might mean for our financing remit. The remit itself is derived from the OBR’s forecast, so the accuracy of our financing requirement is directly linked to the accuracy of the OBR’s forecast. All we have to refer to at the moment is how the outturn borrowing been so far this financial year.
Q: And how much uncertainty are sources of funding subject to for the rest of the year?
A: If that question refers to those investors who buy Gilts at our financing operations, I’m very confident that those sources are robust. Notwithstanding any uncertainties, compared to what we were facing in the spring of last year, everything looks a lot more manageable. I should also add that we sell to a much more diversified investor base than existed 10 or 15 years ago, and we meet demand for different maturities all along the curve, and that investor base has been consistently there for us in terms of demand. In practice we see ongoing demand from UK banks and overseas investors - both of which groups as a rough rule tend to favour shorter-dated maturities. That can also apply to hedge funds. There is also of course the all-important UK pension industry, which favours longer-dated maturities and is a particularly keen buyer of index-linked Gilts. I have seen no indications that that any of this is going to change or that there has recently been any particular shift in the composition of the investor base.
Q: Are there any investor segments not being reached that you’d like to reach? Have you seen any significant changes in the types of investors buying your debt?
A: I referred a moment ago to what I called our diverse investor base. I would add that an important part of our whole debt management approach is also to diversify as much as possible the type of debt that we issue in order to appeal to different types of investors because that gives you an element of protection against any potential risks. We don’t want to be overly reliant on one particular type of investor to absorb our debt issuance. The fact that we have this diversified investor base gives us, we feel, resilience in multiple circumstances. Most importantly, it helps ensure market access, even when things can be challenging. We hold regular discussions with our key investors both here in the UK and also overseas, including Asia, and we have made sure to maintain communications with them throughout the pandemic, even if we haven’t actually seen them in person. We also receive ongoing feedback on investor preferences from the primary dealers, and we’re always open to hearing any views at our so-called annual and quarterly consultation discussions with Gilt-Edged Market Makers and end-investors. The latest sectoral data from the ONS as of the end of March 2021 show that 28% of outstanding Gilts are held by the pension and insurance sector. Another 28% are held by overseas investors, and both groups have been broadly stable between 25% and 30% for about a decade. A further 6% are held by so-called other financial institutions, and 5% by what’s known as monetary financial institutions. Within those sectors there’s a wide range of individual institutional investors. It’s worth noting in terms of international flows that foreign investors bought a record-breaking volume of UK government debt over the last 12 months, and cumulative inflows by overseas investors into Gilts reached £98.1 billion over the last 12 months. Just as an aside, we know that Japanese investors bought a record-breaking amount of UK sovereign securities, about £5 billion on a net basis, in January 2021. We have been told that was due to Brexit uncertainty being lifted. The interesting point is that these big investor groups are pretty diverse. If you looked at the composition of the investor base when I started at the DMO nearly 20 years ago, you would have seen international investors accounting for around 15% or 16% of the base, compared to twice as much as a proportion now and a multiple in terms of nominal size. You would have seen at the time the pension industry completely dominant, accounting for almost two thirds of our issuance. It has a much more balanced feel to it now. So I’m pretty comfortable with that at the moment. We don’t usually try to target any particular investor group, I’m just happy that it is as diversified as it is.
Q: Are you worried about or have you observed a shift in demand away from longer-dated tenors, such that future syndications at the longer end of your curve might not be as successful?
A: In a word, no. I’m confident that demand for long-dated Gilts remains very strong, and looking at the shape of the curve as I speak, 10-year Gilts are around 0.56%, 30-year Gilts yield 0.98% and our 50-year Gilts yield 0.79%, which actually shows slight curve inversion at the very long end. That to me is a strong indication of ongoing real demand for long-dated paper. I would also say that market feedback suggests that maybe some switch of focus from those very long maturities - the 50-year area - to the 20- or 30-year area, probably reflecting the shortening profile of some of the UK domestic pension liabilities. Notwithstanding that no other country in the world has either as long an average maturity debt portfolio or as loyal a long-end focussed investor base as we do. Our recent transactions have shown that demand for long-dated maturities remains very strong, even though yields have come down somewhat from where they were just a few months ago. We see demand as very robust. I’m not worried about that at the moment.
Q: Given that, what is your current view about the desirability of issuing a 100-year bond?
A: It’s not quite clear to me what that would actually offer us. All our decisions about what tenor we issue are ultimately a question about balancing cost and risk, and hence they’re about trying to achieve good value for money. So we already have the longest average debt maturity of our portfolio of any G7 country. It’s about 14.7 years, almost double that of the next nearest country, France, where it’s 8.5 years. If you decide to issue in such very, very long maturities such as 100 years, there is greater uncertainty about the extent of demand. So, when it comes to any curve extension, we prefer to follow a more gradual approach. That is not to say that there is no demand for these very long maturities. We have begun to detect some market interest in a curve extension, potentially later this financial year. But that curve extension, and the interest in it from the market, is very much incremental only. It’s not a question of jumping from 50 to 100 years, it might be going from 50 to 51, 52, 53, or such like. From a bond mathematical perspective, given where interest rates are, the duration of a 50-year bond and that of a 100-year bond are virtually identical. Demand for a 100-year bond is likely to be finite. Given that we always aim to try and build our bonds to large benchmark size, there would be obvious drawbacks in having a single, relatively illiquid issue with a 50-basis-point gap in between any other reference point on the curve. While there is arguably always a price for everything, the value-for-money considerations are currently unlikely to be compelling.
Q: Are you worried about the recent hawkish shift in tone of the BoE and possible changes in their QE programme at the August meeting? Is there a specific plan on how the DMO would react to a possible QE reduction or interest rate hike?
A: The straight answer to that is that we do our level best to be completely unfazed by any developments of this nature. We do not design our issuance programme around what the monetary policy authority, the Bank of England, is or might be doing in terms of QE. Debt issuance and monetary policy are two completely separate things and involve two completely separate decision-making processes. In our approach to the market, we accept that we simply have to take the market price. Our job is not to fund at a particular yield level, but rather to fund cost effectively in relative terms to where yield levels are at any given time. So, if as a result of a decision by the Bank on QE, yields were to rise further down the road, then we would simply end up having to pay whatever the prevailing market price is. I take the view that we are fundamentally a price taker. For us the most important thing is that the market functions as smoothly as possible so that the price can adjust as necessary to absorb the supply that we have to offer to the market. For that reason, our strategy won’t change. We’ve designed our financing remit to be balanced with significant issuance programmes at all key maturities to meet the needs of the investor base. I do not anticipate a problem for the Gilt market if Bank monetary policy changes in whichever form; that is natural in an open economy and capital market and it applies to the market for sovereign bonds that we have here in the UK.
Q: How do you measure the success of issuance, and by that standard, have you been satisfied recently?
A: That’s a good one. We’re just as good as the last transaction that we’ve successfully completed. One metric that enjoys a lot of public focus is the cover ratio at our auctions. Average cover ratios are almost at historical high levels for us. But I personally don’t think that the cover ratio is the best or should be the only metric to measure success in terms of a Gilt auction, because all that a cover ratio does is tell you at the moment an auction closes exactly how many orders you had in relation to what you’re selling. It doesn’t tell you any more; it doesn’t tell you any less. It is merely a snapshot in time. Importantly, it doesn’t tell you what demand might be like 15 minutes before the close of the auction or 15 minutes after the auction. So in addition we tend to focus on one or two other metrics as well which we consider to be quite important, such as what we refer to as the “tail” on conventional gilt auctions, which in the UK is the difference between the average accepted yield and the lowest accepted yield. It’s a measure of concentration of bidding. As a general rule, if you have a tail of less than one basis point, that’s usually a sign of a pretty decent auction. If it’s really small, that could be a sign of a very strong auction. To date, in the current financial year 2021-2022, our average tail has been about 0.2 of a basis point. That’s pretty good. That’s very tight. Another important indication of the success of an auction is the secondary market performance after in the immediate aftermarket. And a strong secondary market afterward could be – not always is, but could be - a positive sign that the auction was well received. It will also tend to trigger something that we refer to as the Post Auction Option Facility. On all these metrics, the post-auction performance this financial year has generally been strong. For syndications, there are rather different performance metrics. For us, the key indicator is the quality rather than the size of the order book: we ask ourselves if these are good-quality investors who we know will support the market in the long term. What I’m particularly happy about recently and what makes me comfortable about the programme right now is that we’ve had a very high level of participation from what we call UK real money investors, which is our core investor base. In most of our recent syndications, this participation was so strong that we actually were able to increase the potential size of the indicated transaction by a billion pounds above what our internal initial planning assumptions in order to facilitate meaningful allocations to UK real money investors. Secondary market trading relative to the price spread fixed on the transaction is also a key indicator, and that has been very satisfactory too.
Q: Where do you see the average maturity of the portfolio heading?
A: The average maturity of the debt portfolio fell last year very marginally from 15.2 to 14.9 years, which reflects the maturity structure of the issuance, simply because we had to raise so much money quickly. If you need to raise a large amount of cash in a short period of time, you have to focus on shorter maturities more than you might be inclined to otherwise. 14.9 years is still very, very high relative to our peers. The other great advantage of the long average maturity is that we will need to refinance this financial year only 4.3% of our debt portfolio, which is roughly £80 billion, and over the next three financial years, we’re only having to refinance 16.3%, which is about £300 billion. Such a refinancing profile is a huge benefit. Perhaps it’s worth mentioning that the OBR in their assessment back in March pointed out the long average maturity, as have the international credit rating agencies. They have also noted that the Bank’s QE purchases effectively shortened that average maturity for the public sector as a whole, due to the large-scale Gilt purchases through the Bank’s Asset Purchase Facility, because in order to finance those purchases, extra central bank reserves needed to be created at Bank rate. Even so, our actual refinancing burden is quite small by international standards.
Q: And where do you see the interest burden heading?
A: That’s a difficult one to answer, because I don’t know what interest rates are going to do. My guess is as good as anyone else’s. What I would say is that given that central bank reserves currently pay an interest rate of 0.1%, whereas the Gilts they effectively refinance pay an average interest rate of just over 2%, there is at present a net savings in terms of the interest burden that the government’s having to pay. But of course, we are potentially exposed more in the future if short-term rates were to rise. There’s an increased sensitivity in terms of debt interest spending to changes in short-term rates, and I need to acknowledge that. As I have mentioned, this is something the OBR has highlighted. If short- and long-term rates were both about 1% higher than the rates used in the forecast, it would increase debt interest costs by something like £20 billion in 2025-2026. But that is of course all hypothetical. None of us know for certain what interest rates are going to do. I cannot be alone in noting that virtually every so-called expert in the world in January, February and March was predicting higher rates. There was a general consensus along the lines of “Right, that’s it, we’ve seen the back end of low rates.” I don’t know whether that’s true or not. All I know is that actually our yields now are some 30 basis points lower than they were a couple of months ago.
Q: In the latest minutes from DMO consultation with GEMMS and investors it seemed there was some interest from participants in a new 50-year index-linked Gilt. Is there still decent demand for long-end index-linked Gilts after the change in RPI-methodology in November?
A: The feedback that we hear is that overall, demand for index-linked Gilts significantly outstrips supply, because investors use those bonds to match long-term liabilities, even after the reform of RPI. As a rule of thumb, the best measure of demand for inflation-linked bonds is so-called the breakeven rate. These may be off some of their recent peaks, but long-end breakeven rates remain very high, which to me suggests that there is still very strong demand for inflation protection, particularly amongst pension funds. We remain open to hearing feedback from the market about the issuance of specific Gilts, including potentially a new ultra-long index-linked Gilt. We’ll be hosting third-quarter consultations with the market on Monday, August 23 and we are going to seek further views then about demand for upcoming operations. But it’s been really a very strong period for this market, and we have noticed that once clarity was achieved around RPI reform, we have seen much more demand for the product.
Q: Could it be worth issuing a new ultra-long-end linker in the current financial year?
A: It might well be, but we will have to see, and we will have to listen very carefully to what our market sources tell us and our assessment of that market. But I certainly don’t want to rule anything out.
Q: What can be expected going forward in terms of green issuance?
A: That’s obviously an area of focus at the moment. Various announcements have been made. We announced as part of the second quarter issuance calendar that the inaugural green Gilt will be issued in September via syndication, subject to investor demand and market conditions. The Government is committed to issuing a minimum of £15 billion of green Gilts in the current financial year, and has also committed to building out a green curve in the coming financial years. We have not yet made any decision on the maturities for green Gilt issuance in the current financial year, and a decision on the timing of any subsequent issues, apart from one in September, still has to be taken. But we will make sure that we communicate that to the market in an open, timely and transparent fashion as part of our regular dialogue with market participants. With the announcement of the decision to launch the first green Gilt in September we hope we will have a bit more time over the next few weeks in particular to canvass further opinion from the market about the appropriate maturity, and again, I’d point to the consultation meetings occurring on the 23rd of August. So we’re not going to make that decision yet, we want to hear first from the market, because we want to make sure that this transaction is a success that it is delivered as smoothly as possible, and that it reflects the overall Gilt market.
Q: Still, does the supposition that it will be 10 or 15 years in September seem reasonable?
A: I’m not going to be drawn on that specifically. If you are suggesting a maturity of that nature, then presumably it’s because you’ve been hearing such comments. We want this green Gilt, especially because it’s going to be the first one, to be a strong success. We want it to reach the right green investors, we want it to sit well in the market, and we want it to enhance the wider Gilt market too. I think it’s fair to say that the maturity that we choose will be the one that we think and hope will probably be the most welcomed by the market for an inaugural issue.
Q: I probably shouldn’t expect you to say much more about the next one, in December.
A: We haven’t actually said in which month it might come. We obviously have to get the first one out of the way first, but we will be doing another one I imagine reasonably soon after. I wouldn’t be surprised if we receive feedback in August about timing for a second issue, because we’re going to be talking in August about the calendar for the October-November-December period
Q: Will the green Gilt have the same maturity as a conventional Gilt in order to make the calculation of the green premium easier for the investors?
A: Not necessarily. It is not obvious that that is needed by the market. We have this very live, well-populated Gilt curve with big liquid issues all the way out to 50 years, so it is very easy for the market to work out where a particular transaction along the curve should be priced if it’s going to offer fair value. If the maturity happens to be very close to that of an existing Gilt, so be it. But if we feel that there’s an opportunity to fill in a gap somewhere on the curve, to make the curve richer, to make the curve more meaningful, then that could be something that we decide to do as well. I’m pretty sure that whatever maturity we choose, the market will be able to calculate pretty easily what the value of that is.
Q: Going back to upcoming conventional syndication plans, can you provide any indication of possible maturities?
A: The short answer is right now, no. I would like to wait to hear what is said in the forthcoming consultation meetings. In the consultation meetings that we held in May, which were issuance in the current quarter, the majority view was for a 2038/2039 maturity, which is what we ultimately ended up issuing. Also 2043 was mentioned as a possibility. There were isolated calls for a new 2036 or 2040. Demand patterns along the curve evolve and change. I would just say that we have an open mind, but we also have to keep our ear very close to the market and make sure that whatever we decide also accords to a large extent with what investors ultimately want.