Shorter-dated tenors could become more common as the UK Debt Management Office adapts to a changing investor base while remit sizes remain elevated. By David Rothnie.
Outgoing UK Debt Management Office chief executive Robert Stheeman signed off in style with his final syndication on June 11, with an £11bn 10-year deal that attracted a record order book of £110bn.
It was a fitting valediction for Stheeman, but the deal itself was also significant because it hinted at the shifting tides his successor, Jessica Pulay, must deal with when she takes over the role on July 1.
That is because aside from the DMO’s green Gilt programme, this was the first time it had issued a syndicated bond with a tenor of less than 15 years except in a crisis. Its debut 10-year came in May 2020, when it raised a £12bn issue the teeth of the Covid pandemic, when funding needs rocketed to an all-time high.
So, the decision to offer a shorter tenor in more normal funding conditions is noteworthy, as looks to meet elevated funding needs against the backdrop of changing investor base. The DMO has established a reputation for consistency, so this shorter-dated deal could become a more regular feature issuance.
"The 10-year syndication catered for a different investor base and the market now expects this tenor to be part of the DMO’s programme going forward," said Ben Nicholl, senior fund manager at Royal London Asset Management.
The 10-year tenor catered proved attractive to a developing group of buyers, with sovereign wealth funds and bank treasury departments making up a bigger portion of the book as traditional long-only pension funds shift their priorities.
The move follows a call in January for the DMO to scale back its issuance of long-dated and inflation-linked bonds as appetite from pension funds for long-dated paper wanes. A big factor was the forced selling by such accounts of "liability-driven" investment strategies triggered by former UK prime minister Liz Truss' mini-budget in 2022.
Craig Inches, head of rates and cash at RLAM, said: “Probably the sweet spot for pension funds now is the 15 to 20-year sector. If you go back five or six years, they were looking for 30-years plus when interest rates were at zero. So there’s been a big shift from ultra-long-dated bonds to more medium maturities.”
Pension funds used to account for 80% of demand in the Gilt market, with the rest coming from overseas buyers. Now, the Bank of England accounts for half of the market, with the rest split roughly between pension funds and overseas buyers, according to Inches.
“Those overseas buyers are changing somewhat. It might have been bank treasury desks in the past, whereas now it’s more active hedge fund money activity. We are an active real money manager, so we are actively taking positions around auctions, then using the liquidity point in the auction to close down some of that risk.”
This shift in buying behaviour does not in itself pose a problem, especially at a time of attractive yields and in an era when debt management offices across the globe are issuing record amounts of debt.
Rocketing remit
Since Stheeman, who is leaving at the end of June after more than two decades at the helm, joined the DMO, the size of the Gilt market, measured by outstanding paper, has rocketed to £2.4trn from £300bn. For 2024–2025, the remit has climbed 16% to £277bn, and it is expected to be around £200bn per annum for the next five years.
While the DMO’s central aim is to get the best possible deal for the UK taxpayer, it knows that execution means being attuned to shifting market and investor trends. That extends to the DMO team – Pulay, who is currently co-head of policy and markets, is a former banker, while the institution continues to add talent. Last year, it recruited Paul Canty, a former trader, as co-head of the dealing desk, following the retirement of Martin Duffell, who stepped down after 25 years.
Having close market connectivity is key, particularly as the DMO relies on syndications as a route to raising large amounts of debt. Syndications continue to account for 20% of the DMO’s total issuance programme, with auctions making up the balance.
The head of SSA at one primary dealer said: “Hiring a well-known trader is a deliberate way to get a deep understanding of how the market works. Their main mission is to do a great job by the taxpayer. So it’s not all about the market, but they understand what they need to do to make that market work for them.”
Stheeman agreed. “As the remits have grown, we’ve relied more on primary dealers and their ability to commit risk capital to their balance sheets around the time of our operations,” he said.
Continuity and consistency
The increased use of the medium and shorter-dated end of the market is down to the need to raise more debt, and Stheeman plays down the suggestions of any big divergence from the norm. Throughout his tenure, his watchword has been consistency, and while Pulay will bring in fresh ideas, she’s also a continuity candidate, having worked as co-head of markets and policy for a decade.
When Stheeman joined, the DMO did not issue anything shorter than 15 years, but growing remits mean taking a view across the curve. “Nowadays, there is no practical way we could skew issuance in isolation to a single part of the curve or specific maturity as we could when we were issuing fewer Gilts," he said.
"In terms of our issuance strategy, the growing size of the financing remits means we have naturally issued all along the curve, in order to spread our issuance and access as broad an investor base as possible. We need to look where investor demand lies, and over the years the composition of the investor base has evolved and is no longer dominated by domestic pension funds and life insurers in quite the same way, and they are showing slightly less appetite for long-end paper.”
The DMO, in common with sovereign issuers across the world, has benefited from increased interest rates, which enabled them to mitigate the retreat of central banks as buyers of last resort following the ending of quantitative easing programmes.
The head of SSA at one primary dealer said: “QE deliberately pushed money out of safe assets into risky assets, so that’s why for the 2010s to 2022 you got a huge growth in other risk assets or alternatives, hedge funds, private equity. As that reverses and yield levels go back up, it’s sucked a lot of money back in. That is a pretty good core to explaining the robust demand we’re seeing.”
The DMO seems to shrug off ever bigger remits. "If there’s any shrugging off going on, it’s in the markets rather than the DMO. The market has shown its ongoing capacity to adapt to a huge change in issuance and to absorb this supply, both in the UK and globally,” said Stheeman.
The question is whether that will continue to be the case, and what might disrupt the flow of sovereign bonds.
QT or not QT
Demand has remained robust and the DMO shown its ability to adapt to previous big market events, such as the start of quantitative tightening, which some predicted would have an adverse effect on the ability to raise debt when the Bank of England ceased to buy bonds.
In fact, it brought unintended consequences. While other investors took up the slack, QT provided a vital source of liquidity to the market and with the current QT programme set to end in September, participants expect it will be extended.
That is because that while the DMO is issuing high-coupon bonds, there is strong demand for low-coupon paper, both from pension funds and high-net-worth individuals who can lock in tax benefits. During QE, the Bank of England bought both high-coupon and low-coupon bonds, but now it is the only seller of low-coupon bonds.
"One the really important things that QT has brought to the market is liquidity, and particularly liquidity in low-coupon bonds. QT is almost like a stabiliser," said RLAM’s Nicholl.
"The Bank of England is aware that if they don’t issue them there could almost be two yield curves in the Gilt market: your low-coupon bonds that trade expensive and high-coupon bonds that are constantly being issued and trade quite cheap. And they don’t really want that dislocation in the market, which is why should continue selling low-coupon bonds back to the market via QT."
Despite a looming general election, a change in prime minister is unlikely to impact the Gilt market. Instead, Pulay is likely to be more focused on smooth execution and the timing and extent of interest rate cuts. The European Central Bank has blinked first, while the US is guiding towards a single cut later in 2024 as it continues to be mindful of inflation.
Investors are positioning themselves for a steepening of the yield curve as rates come down. But the challenge for the DMO is that if interest rates remain high while debt levels continue to rise, investors will demand a higher risk premium.
"This is a big risk for all sovereign bond markets," said RLAM’s Inches. "They got so much supply to issue, that if we don’t get a recession, if we don’t get interest rate cuts, then you can actually see yields move higher. Now, that’s not our central case view. But that’s just one thing that even central bankers need to be aware of. They can’t afford to not slow and cool economies because they’ve got a debt sustainability problem, so they need to be mindful of that."
Above all, sovereign debt markets dislike surprises, something Stheeman has been keen to avoid during his tenure. “Good market functioning is the most important feature,” he said.
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