Charting the future of Gilts

The UK government is expected to borrow massive amounts in coming years to fund the budget deficit. Should UK pension funds be changing the structure of their portfolios in light of the scale of the expected Gilt issuance? 

Peter Best: That's an interesting question. Without doubt there has been a lot of debt issuance over the past year and a half and there will be more to come, but that's not the only consideration for portfolio managers right now.

In the wake of what is commonly referred to as the ‘Credit Crisis' in late 2008, we have seen the Bank of England step in and use pretty much every monetary policy tool available to them to halt the UK economy dipping into what many predicted could be the worst recession since the Second World War. That included cutting base interest rates to almost zero (which of course had the effect of lowering issuance yields and a dramatic steepening of the yield curve), and issuing huge amounts of debt to finance the budget deficit, and overlaying all that issuance with a programme of "Quantitative Easing" (driving bond yields down further and raising bond prices). 

You are absolutely right to point out that there has been massive amounts of net Gilt issuance with plenty more expected to come (another £174bn [US$247.9bn] of net issuance is predicted1 for 2010/2011), but I would venture that every fund manager is still having to consider what is the likely impact of all these policy measures combined and what this means for their portfolio. 

Let's not forget the scale of the actions being taken. This hasn't been monetary tinkering; it's been massive scale macro-economic intervention. The scale of these measures puts us into unchartered and volatile territory. Although the UK is not alone in undertaking monetary intervention, our ‘first mover' status and scale of action has meant that all eyes are on the Bank of England as it attempts to steer a course to recovery. One impact that will be of consideration for all pension fund managers is that the make-up of the UK debt portfolio itself has changed, with the weight of conventional Gilt issuance moving from the classic pension fund terrain of 15 years and longer towards shorter maturities. In addition, as portfolio maturities shorten, many will be considering when and how quickly the curve will start to flatten again. And of course a great many are looking out for signs of inflation to return and for yields to begin to rise all along the curve. 

What I am hearing from every type of user - across every risk-taking time profile, including the very short to the very long - is that they are becoming incredibly alert to the price and performance impact on their portfolios as large scale monetary measures take effect. Hence we are seeing considerable volatility around economic indicators as many try to predict what the next monetary policy step will be, and what impact this will have on yields and portfolio returns. 

Bond prices have a tendency to be volatile at the best of times, hence why we think that portfolio managers need all the tools at their disposal to act quickly, to counterbalance or change the shape of their portfolio. That's really where we see the utility in our Gilt futures contracts and one of the reasons why we have recently launched our ‘Short' and ‘Medium' Gilt futures to complement the existing ‘Long Gilt' future. 

There is considerable uncertainty around the Bank of England's quantitative easing programme under which it purchases Gilts in the market, potentially offsetting the Gilt issuance from the Treasury.  How should pension funds allow for both the uncertainty and the potential long-term effects of quantitative easing? 

Peter Best: I think you've summed it up well here by using the term ‘uncertainty'. Of all the monetary policy tools used, the £200bn asset purchase programme is considered the least orthodox. No-one exactly knows whether the size and duration of the programme will meet its objectives or whether it will undershoot or overshoot its targets. For a fund manager, even the short-term effects are bound to have portfolio implications. Everyone is looking to see when the unwinding will commence, and at what speed and which Gilts will be sold first. All of this has the potential to impact portfolio returns and much of this impact may well be transitionary. 

Again, that is where we see the importance of having tools out there that can hedge portfolio exposure and defend portfolio returns, such as the Short, Medium and Long Gilt futures. Until long term effects are proven, we expect that investment managers will want to use a very cost-effective and liquid tool - preferably an ‘off-balance sheet' derivative that doesn't require a large allocation of capital - enabling them to quickly take or hedge exposure to the kinks in the curve that may distort portfolio performance. 

If the UK government's debt gets downgraded from AAA, what is the risk-free asset for pension funds? 

Peter Best: Everyone is of course entitled to an opinion, and mine is that a business school penchant for "risk-free assets" has probably been overdone. Britain is still the world's sixth biggest manufacturer. We have fantastic and transparent systems of government and law. We've always been open to trade and capital flows. We have an incredibly capable and independent central bank. And we've never in our history ever defaulted on any government debt. Whilst personally I can't predict what the rating agencies may do, I can't see how anyone could possibly think that UK Government debt will not continue to form the benchmark yield curve for sterling denominated assets. 

Quite frankly, I rather think that the ‘rating downgrade' comments that one reads and hears from time to time signals something of an oblique call to the UK government for tighter fiscal measures. However, in my view, with all the major political parties well aware of the fiscal tightening that needs to take place, these are somewhat empty statements. 

Analysts may point to swap prices dropping below government bond yields, but I think this is due to technical factors and is not indicative of the UK (or the US) government debt being more risky than that of corporate debt. If anything, it simply highlights that the assumption underlying many financial models that government debt is "risk-free" needs to be re-examined. Sure, portfolio managers may want to open their portfolios to some corporate bonds, and that's fine, but Gilts will remain the underlying benchmark sterling denominated asset-class for the foreseeable future.

The Gilt market is seen to be both highly liquid and efficient. What scope is there for active managers to add value in this market?  

Peter Best: Indeed, there is plenty of scope for them to add value.  We also think that the DMO has done a tremendous job in recent years of taking the Gilt market to the world and ensuring that foreign ownership of our paper is widespread. With the exception of last year, overseas Gilt holdings have been growing steadily for the bulk of the last decade. Furthermore liquidity (as measured by daily turnover) has been rising steadily too. 

The arrival of bank e-commerce platforms and platforms such as Tradeweb has led to much better price dissemination. And of course we have for many years now quoted prices in decimals and no longer in 32nds.

But all that said we still feel that there is scope to increase price transparency. In fairness this isn't anyone's fault. It's simply been the case that turnover has neither been consistent enough, nor sufficiently centralised (i.e. on one platform), for prices to have become transparent.

One of our hopes is that the short, medium and long Gilt futures contracts will serve as a benchmark to give the market a snapshot at any time during the UK dealing day as to where yields are on those three points of the curve. It's not complete market transparency, but it would certainly be a respectable and reliable yardstick.