|Main index||Financial Markets index||About author|
Julian D. A. Wiseman
Abstract: the UK DMO has announced the sale of a new gilt maturing 22nd January 2060. There are two errors in this choice of maturity date: one traditional, one new.
Publication history: only at www.jdawiseman.com/papers/finmkts/22_january_2060.html. Usual disclaimer and copyright terms apply.
Contents: Introduction; The traditional error; The new error (Why have a new date?, Why not have a new date?).
On 2nd October 2009 the UK Debt Management Office announced the forthcoming sale by syndicate of a new gilt maturing 22nd January 2060. There are two errors in this choice of maturity date: one traditional, one new.
In an earlier essay, Bonds: too many; too small, dated September 2006, the author argued that governments currently issue debt securities that are too numerous and hence too small. There are two reasons for having multiple securities, but neither supports the growing profusion of gilts.
Reason 1: Cashflow dispersion
Governments should want their debt cashflows to be dispersed over time. If there were only one bond maturity every half decade, government finances would be pushed into cycles of relative plenty followed by severe dearth. … But this desideratum bites only for short-dated paper: bonds about to mature need to be evenly spaced. Longer-dated bonds do not need such evenness, as any uneven spacing can be ‘fixed’ later, either by judicious choice of maturity of new issues (if the government is in deficit), or by buying back out-sized bonds (if in surplus) or both (if the budget is nearly balanced).
Reason 2: Meeting investors’ needs to offset liabilities
If some investors have, say, 30-year liabilities, and the longest bond is currently 15 years, then one would expect investors to be willing to pay a good price for an asset that would offset this 30-year liability. Likewise, if there were 5-year and 30-year bonds, but none between, investors with liabilities between should be willing to pay a good price for 10- or 20-year bonds.
But careful qualification is appropriate. Imagine that there are already 20- and 30-year bonds outstanding. Investors might still have a need for a 25-year bond if, and only if, such a security could not be replicated with some combination of the existing 20- and 30-year bonds.
Near 50 years maturity two government bonds with maturities differing by 4 years and 46 days are extremely good hedges for each other. Having two smaller bonds rather than one larger one reduces liquidity; investors like liquidity and so (should) charge for this reduction by demanding a higher yield. Hence that essay concluded “if issued before 2015, the next new post-15-year gilt should mature not before 2080”.
The 4¼% Dec 2055 is currently £20.147bn. If nominal growth in GDP (so real growth + inflation) averages a rather low 3%, rather than the 5%+ average since the mid-1990s, then at maturity the 2055 will be the same fraction of GDP as £5.2bn in 2009. Compare to the 4½% March 2013, which is now £29.287bn; if the 2055 were the same size, discounting at 3%, it would have a nominal size of just over £100bn. Hence the DMO should either have reopened the 2055 (repeatedly, until ≥£100bn) or allowed investors to purchase something new, that is, maturing ≥2080. Doing neither was an error, but at least it was a traditional error.
But there is a new error in the choice of maturity date: why 22nd January rather than 7th June or December?
There is a good reason to create a new coupon date, and a good reason not to create new longs with a new coupon date.
Almost all gilts pay semi-annual coupons. The more gilts that pay on the same dates, the larger will be the payments on those dates. Conventional gilts currently pay coupons of about £31bn per year; if they paid on just one coupon series (say, 7th June and 7th December), then each of those payments would be almost £16bn. That is a lot, and hence the UK DMO should wish to spread payments over more dates. However, this need would be equally satisfied by having the long gilts, and the formerly-long gilts, paying 7th June and 7th December, and some of the non-long gilts paying on other dates.
Having matching coupon dates facilitates stripping. A strip facility allows a holder of a gilt to exchange the gilt, in return for Separately Tradable Registered Interest and Principal Securities. That is, a holder can break the bond into constituent cashflows. But there’s a problem. For a completely-stripped £10bn gilt, with a coupon of 4%, the last coupon strip, if it yields 4%, has a value of £61mn. This size is tiny, inviting market manipulation and, in fear of that, causing illiquidity. Hence all strippable government bond markets have multiple bonds paying coupons on the same dates.
as of 15th October 2009
|5¾% Dec 2009||£15.60bn|
|4¾% Jun 2010||£21.29bn|
|6¼% Nov 2010||£6.72bn|
|4¼% Mar 2011||£23.65bn|
|9% Jul 2011||£7.31bn|
|3¼% Dec 2011||£15.75bn|
|5% Mar 2012||£26.87bn|
|5¼% Jun 2012||£21.58bn|
|Short||4½% Mar 2013||£29.29bn|
|8% Sep 2013||£8.38bn|
|2¼% Mar 2014||£29.12bn|
|5% Sep 2014||£23.18bn|
|4¾% Sep 2015||£24.97bn|
|8% Dec 2015||£10.00bn|
|4% Sep 2016||£25.83bn|
|Medium||8¾% Aug 2017||£10.50bn|
|5% Mar 2018||£22.39bn|
|4½% Mar 2019||£26.30bn|
|3¾% Sep 2019||£11.97bn|
|4¾% Mar 2020||£16.62bn|
|8% Jun 2021||£22.69bn|
|4% Mar 2022||£13.80bn|
|Long||5% Mar 2025||£22.10bn|
|4¼% Dec 2027||£21.43bn|
|6% Dec 2028||£16.93bn|
|4¾% Dec 2030||£21.26bn|
|4¼% Jun 2032||£23.62bn|
|4½% Sep 2034||£7.00bn|
|4¼% Mar 2036||£20.23bn|
|4¾% Dec 2038||£22.76bn|
|4¼% Sep 2039||£9.30bn|
|4½% Dec 2042||£19.12bn|
|4¼% Dec 2046||£17.75bn|
|4¼% Dec 2049||£14.01bn|
|4¼% Dec 2055||£20.15bn|
But the gilt strip market is functionally dead, in that it never trades. This might be thought to remove the need for matching payment dates. No it doesn’t: there is a solution to the strip-market problem, but a solution requiring matching dates. For this we turn to ¶33 of this author’s reply to the DMO’s consultation that resulted in the issuance of the 4¼% Dec 2055.
33 However, there is something the DMO can do. It should also allow the new gilt to be partially strippable into, and reconstitutable from, two securities: a ‘2020 annuity’, composed of the coupons up to the first coupon of 2020; and a ‘2020+ talon’, composed of the coupons and principal after that date. Each of these would have substantial present value, of about half the value of the whole gilt.
34 The talon would be an instrument with extremely long duration. As of 15 years before the annuity’s last coupon, the Macaulay duration of the talon would be 15 years plus the duration of the par gilt forward to the that last coupon date. For a par gilt presumed to have 35 years life then remaining and yielding 4½%, this is 17.9 years, for a total duration of 32.9 years. Hence this instrument would have a duration longer than that of almost any other government security, within or without the UK, yet would have a maximum present value of many billions of pounds. This combination has a chance of generating demand and some liquidity.
36 There are some relevant details. … An annuity, like a coupon strip, would not be identified with its source. If, in the future, other gilts were to become similarly partially strippable, annuities with the same cashflows … would be fungible. Annuities should also be strippable into, and reconstitutable from, their constituent coupons. …
37 In time, perhaps in most of a decade, the DMO might wish to allow the ultra-long gilt to be partially strippable also into an annuity with a later end date, perhaps 2030, and a talon with matching start date. Alternatively, perhaps the 2020+ talon could become partially strippable, into a forward annuity containing the coupons from 2020 to the first in 2030, and a 2030+ talon, comprised of the cashflows from then onwards. …
Partial-strippability would cost the government approximately nothing: maybe a few tens of thousands of pounds of set-up costs. What would it be worth? Let’s hypothesise that the long talon would trade 3bp dear to the current curve, as it would be a low-cash way to meet the duration needs of much of the UK investor base. Maturity dependent, the duration might be 35 years or more. So half the value of the gilt might trade +1% expensive, suggesting an improvement to long prices by something like +½%. If selling £50bn per year, that is worth ≈£250mn per year. Of course, the talon might not trade 3bp dear. It might be 10bp (at which price I might want to be short), and it might be nothing. But the worst possible case is no loss, and there are plausible cases worth hundreds of millions of pounds a year.
This hasn’t yet happened. But a new government, perhaps receptive to new ideas, appears to be imminent. The spreading of cashflows could be just as well achieved in shorts or mediums, without this slight reduction in the effectiveness of a future government’s improvement to funding policy.
The essay quoted earlier, Bonds: too many; too small, concluded “if issued before 2015, the next new post-15-year gilt should mature not before 2080 (and on 7th June or 7th December, to facilitate partial strippability). Until then keep re-opening the 4¼% December 2055, or at least until it is most of £100bn”.
But the authorities have been unwilling to make gilts so large, so turn instead to the table on the right, which shows the conventional gilts in issue as of 15th October 2009. There are two gilt ‘series’: 7th June/December (shown in pale blue), and 7th March/September (pale green). There are also a few old gilts with coupon dates that match no other, shown in white. Observe that most long gilts pay coupons on 7th June and 7th December. The new gilt should have done likewise. It should also have been much longer: perhaps Friday 7th June 2080; perhaps Thursday 7th June 2085. New medium gilts could pay on 7th March and 7th September. And new short gilts, of which there are likely to be very many, could pay on other dates, perhaps including 22nd January and July.
But this is too late. The 4% 22nd January 2060 is to be issued this month. If the new government does encourage the DMO to take larger steps that would save money, this gilt might never be large or liquid. Perhaps, later, there will be a switch auction into a partially-strippable gilt paying on 7th June and December?
|— Julian D. A. Wiseman|
Paris, 15th October 2009
|Main index||Top||About author|