The UK Debt Management Office has adopted a flexible funding programme that is a sign of the times as it grapples with higher-for-longer inflation and quantitative tightening. By David Rothnie.
After the Covid pandemic forced the debt management office to raise a record amount of debt, Sir Robert Stheeman, chief executive of the UK DMO, was enjoying a less eventful 2022 until Liz Truss became prime minister and tore up economic orthodoxy with her so-called mini-budget, a package of unfunded tax cuts that sent the market into meltdown and threw grit into the gears of the DMO's funding plans.
But worse was to come. At 11am on September 28 2022, the DMO was about to price a £4.5bn green Gilt with an order book of £30bn when the Bank of England announced it was buying long-dated government bonds due to ‘material risk’ to the UK financial stability.
Legally, the DMO was not required to offer investors the ability to withdraw their offers to purchase, but it reached out to the lead managers to check they were comfortable with the process. Despite the turmoil, which saw yields drop by 30bp, the transaction remained on track, pricing slightly later than planned, at 1.21pm. "The number of orders pulled was very limited. That in itself was a reassuring sign for us and for the rest of the market," said one bookrunner.
One dealer who worked on several transactions said: “The DMO showed its experience through maintaining excellent dialogue with primary dealers and investors to understand how to tailor its funding programme to increase the probability of the debt being absorbed.”
But the challenges did not end there. The Truss government’s ‘growth plan’ forced the DMO to increase its issuance programme for 2023 by £72.4bn to £234.1bn, leaving it with a relatively short period left of the financial year in which to execute a very sizeable increase in its bond issuance requirements.
The DMO responded with a flexible approach, cutting the duration of its programme as it announced a series of fresh auctions.
"We went for that part of the market that was deepest and gave us the best chance to raise funds at pace smoothly without causing disruption,” said Stheeman. “That meant that the overall structure of our Gilt remit shifted more towards the short and medium end of the curve in relative terms. That was a necessity.”
For Stheeman, who was in constant contact with the Treasury and the banks, it was important for the DMO to show stability during a time of turmoil. “At the height of the turbulence and its aftermath, we did our utmost not to change pre-announced plans. This is where we would like to think that years of cultivating relationships with the investor base as well as years of pursuing an open, predictable, transparent issuance policy has paid off.”
Ultimately, the turmoil of September soon abated with the arrival of a new administration which unwound the government’s plans, meaning that the additional funding was not required. That enabled the DMO to reset its remit. “The market turfed out the Truss government and the position the UK finds itself in is not dramatically different from the position that most sovereigns find themselves in,” said one dealer.
On March 16, the DMO announced a funding plan of £239.1.bn for the next 12 months. While that represents a large drop on the £439bn record raised in the teeth of the Covid pandemic in 2020, it is still a big increase on the £136bn from the previous year. But, more importantly, the end of quantitative easing is driving up the government’s borrowing costs because it means that with the Bank of England throwing crisis-era asset buying programme into reverse, the market must absorb a record net supply of Gilts in 2023–24.
New world of QT
The phenomenon of quantitative tightening informs how the DMO shaped its remit for the current fiscal year. "It's designed with a focus on deliverability. We have tried to come up with a remit that the market can absorb with as little friction as possible,” said Stheeman.
QT has proved a challenge for both the DMO and dealers. “During quantitative easing, we could buy Gilts in the morning then sell them to the Bank in the afternoon at a profit. It was like falling off a log,” said one dealer.
But despite the BoE disappearing as a buyer, bankers say they have not seen any evidence of indigestion or investor push-back.
The DMO raises more long-dated debt than any other sovereign borrower and it remains committed to do so, but this year the proportion of total issuance of more than 15 years will be 21%, down from 28.5%.
“The market is less able to absorb significantly large amounts of long-dated and inflation-linked in big size on a very frequent basis. Those instruments are more duration-heavy, they use up more balance sheet for the intermediaries and are more difficult to absorb,” said one banker.
So, one of the biggest tweaks is in shifting issuance to the front end of the curve. As at March 16 2023, the DMO said it plans to raise 36% of its remit in shorts – defined as up to seven years – compared with 30% a year ago.
There are also more syndications in nominal terms, with sales of around £27bn via syndication planned in the DMO’s 2023–24 financing remit. Of that, it plans to raise £18bn of long conventional Gilts in four transactions and £9bn of index-linked Gilts in three transactions.
The DMO kicked off the syndication programme on April 26, when it priced a £4.5bn index-linked Gilt with a new issue concession of 125bp, following that with a a 40-year conventional bond during the week of May 15.
“They have increased the amount of syndications so that they can adapt to the market in terms of price discovery and get more flex on price and duration,” said one bookrunner who worked on the index-linked bond.
"We see ourselves as a price taker," said Stheeman. "We don’t try to target a particular level at which we want to sell. At such time as we have record levels of net supply, if yields need to rise in order for the market to absorb that supply smoothly, then so be it.”
Building up
The drop in the amount of index-linked supply could be interpreted as a response to concerns for the burden on the taxpayer, given that inflation remains stubbornly high. But, while the DMO remains adaptable to changing market conditions, it refuses to budge from one of its golden rules. The DMO’s approach means that once it decides to issue a certain type of Gilt, it remains committed to building liquidity and benchmark size, hence it will not dramatically dial down the amount of linkers purely because of its cost to the taxpayer.
It is taking a similar approach to green Gilts. This year, it is planning to tap its existing curve rather than looking at new issuance.
“We want to focus the firepower on building liquidity in existing bonds because that is what the market values," said Stheeman. "We want to do exactly the same with green Gilts in terms of building them up over time, because it enhances liquidity, improves the trading performance and we achieve a benchmark premium.”
In September, the DMO’s financing remit may have appeared to be in peril as it faced a massive hike in its funding plans.
“There was a real concern about how it would manage to raise its increased remit given the disappearance of the Bank of England as a buyer,” said one fund manager.
But, with a new government taking a more responsible fiscal approach, issuance is back on track and bankers expect the DMO to navigate the challenge of record net supply. “I could not have anticipated how well supply has been absorbed given QT,” said the head of SSA DCM at one US bank. “This has been a story of redemption. The market spat out the Truss government but the DMO performed quite brilliantly.”
With a general election set for 2025, participants are sanguine about the possibility of a Labour government.
“On a political note, the market would be okay with Keir Starmer as prime minister and Rachel Reeves as chancellor," said the SSA head. "Particularly Reeves, who used to work at HMT and is totally part of the establishment. We are stuck in high inflation, low growth but that’s because of political decisions that were made a long time ago.”
But while the UK may have entered calmer political waters, pressure on Gilt prices are not going away as the DMO grapples with record net supply. And there are signs that investors are starting to demand a bigger premium, something that will define the rest of the fiscal year.
Also, it is not just the BoE which is selling. According to data from the UK central bank, overseas investors were net sellers of Gilts every month this year, totalling £36bn in the first quarter, compared with net purchases of £40bn in 2022.
For Stheeman, the key to navigating this will be to stay true to his mantra. "We try to be consistent. Maintaining credibility with the market was the biggest lesson from the events of last autumn."
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