LDI

2019 LDI Survey - Summer Bulletin

Issuance skew, supply & demand
June 2019

Rosa Fenwick

Director, LDI Portfolio Manager

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Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Past performance should not be seen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Since the financial crisis, the UK government bond market has developed and evolved in many ways.  An explosion in issuance was balanced by increasing demand from more than just traditional market participants.  The Bank of England has come from nowhere to be the third largest government bond holder via its quantitative easing (QE) programme.  The recession-busting increase in issuance has ensured LDI portfolios have access to a coherent spectrum of government bonds for their hedging programmes, and happily the increased demand which seems to absorb any available capacity has actually caused gilts to outperform versus their swap comparators.  With government bonds having outperformed swaps over the past few years, what does the future hold for gilts?  As significant holders of government bonds the potential supply and demand dynamics are of critical importance to pension funds, and to that end, we questioned our bank counterparties on this topic.

As with any successful supply venture, the Debt Management Office (DMO) tend to skew their issuance to match demand.  The chart below shows how the composition of investors has developed with time:

Risk Disclaimer

The views and opinions expressed in this article by the author do not necessarily represent those of BMO Global Asset Management.

The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

Past performance should not be seen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currency movements and investors may
not get back the original amount invested.

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Traditional government bond holders such as insurance companies and pension funds have faced stiff competition since the financial crisis.  Their combined share of issuance has gone from c. 60% to approximately one third whilst the Bank of England, and to a lesser extent overseas investors have largely taken up the differential 30%.  Each of these investor types have different ‘sweet spots’ where they prefer to invest and by wielding judgement as to how these sectors will evolve, the DMO can tilt its issuance to match the keenest demand.  This is vital as ultimately the DMO’s job is to issue debt at optimal yields, and increased demand will allow the DMO to be thrifty in the long term by driving down the cost of borrowing. 

Pension funds have historically focused on longer tenor & index-linked issuance whereas overseas investors typically favour the short end (this sector includes global central banks).  If we had asked a question about the make-up of the investor base a mere few months ago, it is likely that our counterparties would have promoted the spectre of an unwind of the QE portfolio.  This attitude has undergone a wholesale shift, with none of our counterparties expecting this to occur for a significant period, indeed current guidance suggests that the Asset Purchase Facility (APF) reinvestments will persist until the Bank Rate has reached the lofty heights of 1.50%.  Projected reinvestment flows total £36bn in 2019, £19bn in 2020 and £59bn in 2021. 

Overseas investors are expected to remain net buyers, in particular in the sub 5-year sector, although there is an element of risk and potential volatility around Brexit and a possible general election.  The absolute amount of supply also has an impact on sector allocation.  This year, outstanding issuance has risen to £114.1bn and is expected to rise further in the subsequent fiscal year.  Beyond this point the supply is forecast to decline slowly.  Some of our counterparties have highlighted that the risks to total supply are very much to the upside as the estimates by the Office for Budget Responsibility (OBR) could be described as leaning to the more optimistic side on taxes and privatisation revenues. 

Equally there is the potential for a loosening of fiscal policy with a new Conservative leader and the potential for even more loosening in the event of a general election and a Labour win.  This is relevant as when there is heightened issuance, the DMO will typically focus on shorter duration supply so as to ensure that the market can digest it.

The chart below represents the total level of issuance and the allocation to the different sectors.  Shorts = 0-7yrs, Mediums = 7-15yrs, Longs = 15yrs+

Over the last few years, issuance has been relatively evenly split between the four segments.  Yet over this time the stock of long-dated and particularly index-linked issuance has built up.  (This chart also gives a sense of the scale of the ballooning of the UK debt).  Despite the relative youth of the index-linked segment it now composes over 33% of the outstanding debt.  As much of this is tilted towards longer maturities and the linkage to RPI it is likely that this will continue to grow as a proportion of the total debt.  Cognisant of this and uncomfortable with the impact that this will have on their future management of the debt, the DMO have signposted their intention to reduce index-linked gilt supply.  Hence the DMO will reduce index-linked issuance by 2% in the coming fiscal year and our counterparties universally expect this trend to continue, at the very least until index-linked supply forms only 15% of total annual issuance. 

Another factor in support of this move is the current uncertainty surrounding the Government’s response to the House of Lord’s inquiry into the future of RPI.  Whilst the indications are relatively muted there is certainly the potential for a curve-ball either in CPI issuance or a material reform to RPI.  Not only has index-linked gilt issuance fallen, it has also been skewed away from the ultra-long end.  Several of our counterparties now predict that there will be no further extension to the index-linked gilt curve (currently maxed out at 2068).  This tilt away from the longer tenors is because of falling longevity assumptions in pension funds and a perception that demand is more focussed on the sub 30-year sector.  Yet the lack of index-linked gilt issuance coupled with the shortening durations has restricted supply whilst demand remains buoyant and has pushed down real yields to new all-time lows.

Whilst some of our counterparties believe that the DMO may accelerate its reduction of index-linked gilt issuance if RPI seems to indicate higher than budgeted prints, others point out that if the index-linked gilt market outperforms significantly then they may be moved to compensate with an increase in longer-dated issuance.

In the conventional gilt space, there is a quiet revolution underway in pension fund demand. As previously mentioned the reversal in longevity has dampened ultra-long tenor requirements, and a number of market participants expect a further deterioration in longevity.  Yet others view longevity to have been overstated compared to other factors including transfers out, and the impact of easier access to balance sheet to support leverage.  At the peak of the repo balance sheet squeeze, many market participants focussed on ‘bang for buck’ hedging, i.e. buying the highest duration bonds to reduce their reliance on leverage financing, which resulted in active curve positions versus liabilities.  The recent recovery in funding ratios partially due to strong equity returns has focused minds upon end-game solutions.  This has taken a number of forms, the two main ones being interest in CDI or Cashflow Driven Investment and buy-outs or buy-ins.  A more cashflow driven hedging solution will typically not take large curve positions and as access to repo has improved there have been notable switches out of 50yr assets into 30yr – this impact is visible in the shift in curves:

Our counterparties agree that the DMO has noted this trend and will continue it’s habit of skewing issuance towards medium and short rather than long and ultra-long gilts.   .  In a buy-out scenario a pension fund will typically deliver government bonds, however the insurance companies will then transform these into credit and inflation swaps in order to meet their Solvency II requirements.  This combined with the projected strong pipeline of buy-outs have led many of our counterparties to predict that demand for longs will drop significantly, potentially resulting in pension funds and insurance companies becoming net sellers in the near term.  This was balanced by one counterparty who bucked the curve as they expect improved funding ratios to unlock more de-risking interest and hence increase demand for longs.

There are a number of risk factors and significant political uncertainty in any prediction of the future, particularly on this contentious topic.  However, as noted the consensus view of our counterparties (in the absence of a marked shift in sentiment/Brexit evolution) can be summed up as follows: the trend of de-risking acceleration as pension fund funding ratios improve will continue apace, along with increased focus on the potential to move to buy-in or -out.  The DMO will adjust their issuance to reduce their reliance on long-dated index-linked gilts and ultra-long nominal supply, with the added benefit of this being easier for the market to absorb in the event of adverse fiscal or economic consequences.  Finally while the buy-out market may reduce the proportional holdings of pension funds and insurance companies, demand will remain strong as the Bank of England have little capacity to unwind their exposure.

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