Who will buy gilts? - PDF document

Who will buy gilts? Keith Wade, Chief Economist , and James Bilson, Economist February 2013 In a September 2012 Talking Point piece we suggested that the changing dynamics of the world economy would create a fundamental shift in the demand drivers for US t reasuries between now and 2017. These include smaller trade surpluses from emerging Asia and a re ticence to continue recycling these surpluses into US federal debt . A significant proportion of the recent net Treasury issuance has been purchased by the Federal Reserve, a price - insensitive buyer. Though the Fed is still purchasing t reasuries through q uantitative e asing, the gradual normalisation of monetary policy will place an increased burden on price - sensitive buyers, such as the domestic private sector, to soak up issuance. Over the medium term, upward pressure on Treasury yields will be required t o induce these investors to purchase these assets. In addition, financial repression, such as imposing minimum Treasury holdings in pension portfolios, could become an increasingly appealing method of filling the funding gap. In this paper , we investigate the likely dynamics of the UK g ilt market over the medium term. Is the funding gap for the UK government larger than in the US? Will g ilts suffer from reduced buying by Asian central banks like t reasuries? Do UK investors have the willingness and ability to absorb financial repression to the same extent as their transatlantic counterparts? Our conclusions are : - HM Treasury has a significant amount of issuance to place in the next five years, as the sizable structural element and weak economy keeps the def icit elevated - The Bank of England has only recently entered the g ilt market, but is already a dominant player. We expect it will continue to buy assets to a total of £450bn, which will help place some of the issuance - The external sector is likely to cont inue buying but , with reduced trade surpluses as the world rebalances, the rate of buying is likely to slow - Domestic banks are unlikely to contribute much due to easing liquidity rules and already improved liquidity positions, increasing the burden on the non - banking domestic private sector - We see pension and insurance funds contributing about £135bn, more than double than the previous five years, driven by capital requirements and the global shortage of ‘ safe ’ assets - It is conceivable, however, that more forceful legislation, such as minimum g ilt/asset ratios, is implemented to assist the Treasury in placing its issuance - A large burden will fall on households and co mpanies . Though there are structural forces pushing t he m towards increasing g ilt holdings, higher yields will be needed to induce th em to buy in the long term . Higher yields are also needed if we are to see a funding switch from price - insensitive buyers (the domestic central bank) to other price - sensitive b uyers Keith Wade James Bilson Talking Point Who will buy gilts? For professional investors and advis e rs only 2 How much issuance needs absorbing? Our piece on the US Treasury market used IMF forecasts of the budget deficit to gauge the likely net issuance. Here, we use the latest estimates from the independent Office of Budget Responsibility (OBR), presented at the Autumn Statement in December 2012. Using this, we estimate that the HM Treasury ’s net g ilt issuance will be around £440bn in total between now and April 2017, approximately 29% of 2011 GDP . This is slightly below the net issuance we predicted for the US (37% of 2011 GDP between 2012 and 2017). As shown in chart 1, the bulk of this net issuance should occur in the early part of the period, with the economy’s cyclical weakness combin ed with the sizab le structural element creating a large deficit. With the coalition’s fiscal plan seeking to entirely eradicate the structural component by 2018 (previously 2015, and then 2017), and the expected cyclical improvement over the next five years, deficits towar ds the end of this period should be more moderate. Chart 1: The supply pipeline Source: Office of Budget Responsibility (OBR), Schroders. December 2012. *Figures include the benefits of the Royal Mail pension transfer, the 4G spectrum licencing revenue and the reclassification of Bradford & Bingley and Northern Rock Asset M anagement; but exclude the revenue from the APF transfer as this is likely to reverse in the future. Of course, there are risks that these forecasts are either overly - optimistic or pessimistic (the odds are probably skewed more heavily towards the former), which would make the funding arithmetic more or less arduous than we project. OBR forecasts for growth have proven too optimistic in the past, and this would certainl y put more pressure on the level of net issuance. Additionally, the UK issuance numbers have been distorted by some specific factors, such as the sale of 4G mobile spectrum licences, transfer of Royal Mail pension assets to the public sector and the recent decision to transfer the Bank of England’s g ilt coupons back to the Treasury (APF transfer). In our figure of nearly £440bn, we include the benefit to the Treasury of these one - off effects, with the exception of the revenue from the APF transfer, citing t he fact that these flows are likely to be reversed at some stage (as the B ank o f E ngland crystallises a capital loss on maturing g ilts). Nonetheless, it is clear there is a sizable wave of issuance on the horizon which must be placed. How has the g ilt mar ket changed since the crisis? The difference between the g ilt market in 2012 and immediately before the g lobal f inancial c risis of 2008 is marked, due to the presence of a previously absent participant - the Bank of England (BoE). The central bank has gone from holding no g ilts to holding over £350bn by June 2012, with a further £25bn of asset purchases required to bring the Bank to its target level. Unlike the US, where the Fed always held Treasury securities, and thus its share of the market increased onl y marginally through q uantitative e asing (QE) , the BoE has gone from zero to over a quarter - share of the g ilt market in four and a half years. I n terms of share of the market, the BoE’s entrance has come almost entirely at the expense of pension and insurance funds (chart 2); who have gone from owning half the market to a quarter. The other big change has been the holdings of banks and building societies, which have gone from a net short position in g ilts to owning nearly 10% of the market between 2007 and 2012. This has come at the expense of other financial institutions (money market funds, financial intermediaries, non - bank brokers and dealers, credit unions etc. ). The external sector has retained its sh are at around one - third, the majority of which is held by overseas households, financials and non - financial corporates. Talking Point Who will buy gilts? For professional investors and advis e rs only 3 Chart 2: The g ilt market has radically altered over the past five years Source: Debt Management Office (DMO), Schroders. December 2012. Who is going to buy g ilts going forward? Between December 2007 and June 2012, UK government debt increased by nearly £800bn, of which the BoE soaked up almost £350bn (44%), the external sec tor (£226bn, 28%) and banks and building societies (£123bn, 15%). Our forecast is for net issuance to be lower going forward, as the government spending plans rein in the deficit, but we also assume that the BoE will play a reduced role in soaking up this issuance, leaving a sizable gap to be filled by the domestic private sector. Schroders Economics Group ’s baseline scenario is that the BoE will eventually hold £450bn of g ilts and will not unwind these holdings before 2017. The current target is £375bn, and as at June 2012 the Bank held around £350bn, implying that a further £100bn of purchases will be required from those levels. Were even more QE to occur, it would further ease the government’s funding pressures. Nonetheless, our baseline forecast of nearly £100bn further asset purchases by the Bank is a sizable (23%) contribution towards the nation’s funding needs. 1 Our assumption is that e merging m arkets, particularly in Asia, will continue to recycle a portion of their trade surpluses into UK gilt holdings. But the expectations that these surpluses will be reduced going forward, as the world economy rebalances and the developed world continues to de - lever, will reduce th e buying rate from this sector. We have the external sector coming in at around £160bn (36%) of purchases by 2017. Though the absolute amount of g ilts purchased by the external sector is lower, the fall in total g ilt issuance leads this sector’s share of p urchases to increase relative to the previous five years. So, with around £440bn of issuance likely by 2017, of which around £100bn will come from the BoE and £160bn from external investors, can the domestic private sector be called upon to purchase the remaining £180bn, having already purchased nearly £220bn since the end of 2007? The answer, we believe, will be that institutional investors (pension and insurance funds) and the private non - financial sector will be left to pick up the remainder, with the former purchasing around £135bn (31%), and the latter just under £45bn (10%); with the domestic banking sector unlikely to contribute. If net purchases over the next five years follow this pattern, it would imply a substantially different profile of buyin g to that we have recently seen (chart 3). 1 To clarify, t he BoE is not allowed to buy g ilts in the primary market, only the secondary market, to avoid direct government financing. Thus, though we expect the Bank to purchase £100bn of the issuance, it will require the formality of somebody else buying it first in the primary market and sellin g it on to the Bank. But with the Bank known to be buying a certain quantity in the secondary market, this will spur demand in the primary market. Talking Point Who will buy gilts? For professional investors and advis e rs only 4 Chart 3: With BoE buying slowing, other sectors will have to fill the gap Source: DMO, Schroders. January 2012. Domestic institutional investors expected to step up purchases In the case of institutional investors, this may come voluntarily or more forcefully via legislation. We believe there is scope for institutional investors to purchase just over £135bn by holding 17% of total assets as g ilts. By the end of 2011, these inst itutions held around £310bn of g ilts out of total assets of approximately £2.5tn (12.4%); increasing this to 17% would require an acceleration in purchases. There are forces already driving pension and insurance funds to hold greater allocations, such as Solvency II legislation, which requires European Union insurers to have certain capital and liquidity characteristics within their portfolio s . With the global shortage of safe assets, as a result of the US housing and e urozone crises turning a number of s ecurities ‘ toxic ’ , g ilts have become even more attractive to investors facing regulatory scrutiny. Indeed, it is likely that non - domestic institutional investors facing tougher capital requirements will also find UK sovereign debt an attractive market to i nvest in. Thus, the rise in the g ilts/assets ratio may be as much down to a lack of alternative safe haven assets as legislation. However, if the funding mathematics remains difficult, and institutional investors are not soaking up much of the issuance, th e calls for more forceful regulation are likely to get louder. Talking Point Who will buy gilts? For professional investors and advis e rs only 5 Additionally, the strong growth in Liability - Driven Investment (LDI) strategies would support increased purchases of g ilts from institutional investors. LDI strategies attempt to match the lia bilities and assets of investors, such as pension funds, to ensure that future cash outflows (such as pension payments) are matched by inflows from assets (e.g. bond coupons). As highly liquid securities, with regular guaranteed coupons, g ilts are one of t he primary assets used for this type of investing. It is likely an increasing number of firms will use some form of LDI in their investment strategies, and this could provide a key underpinning for the g ilt market. Having been on negative watch from all three rating agencies, the recent downgrade of UK public debt from Aaa to Aa1 by Moody’s comes as little surprise, with Fitch and Standard & Poor’s likely to follow suit at some stage. Though there are some institutio nal mandates that require only triple - A rated securities to be held, which may lead to forced sales, we believe the effect of the downgrade on the demand for gilts by institutional investors will be muted, given the global shortage of “safe” assets and the ability of gilts to mimic the liability structures of many pension and insurance funds. Little contribution from the banking se ctor Other areas of the financial sector, however, may not contribute to the same extent. Having been net short of g ilts going into the financial crisis, the domestic banking sector has contributed significantly to absorbing the issuance from the Treasury over the past five years, both as a means of de - risking and to improve liquidity profiles, now holding around £120bn of g ilts. In June 2012, however, liquidity requirements for the banks were eased with the decision to allow assets held as collateral in the Bank of England’s Extended Collateral Term Repo (ECTR) facility as part of their liquidity buffers, which was previousl y not allowed. This has significantly eased the liquidity requirements for the UK banking system, and with the expected return on g ilts going forward likely to be poor , the incentive for the banking system to purchase more is limited. In conjunction with our in - house bank analysts, who cite the eased liquidity requirements and the cost of having big liquidity buffers, we assume the domestic banking system maintains its current holding in absolute terms, with no net purchases or sales, which would reduce i ts share of the overall g ilt market to about 7% in 2017. We also assume ‘ other financials ’ will make no net purchases or sales. If anything, our banking analysts feel that the risk is that the domestic banking sector is a net seller over the next five year s, further increasing the funding burden on other sectors. So of the £440bn issued, roughly £100bn is purchased by the Bank, £160bn by the external sector, £135bn by institutional investors and just under £45bn from private non - financials; with the impact on the g ilt market shown in chart 4. The share of the market held by the BoE and institutional investors will be barely changed, owning around half of the market. The domestic private non - financial sector is expected to take up some of the slack left by t he lack of purchases from the banking system Chart 4: The g ilt market in 2017? Source: Schroders. January 2012. In an historical context (chart 5), these projections would still leave institutional investors owning a far smaller share of the g ilt mar ket than they used to, primarily the result of the increased participation of the external sector and since 2008 the entry in to the market by the BoE. Talking Point Who will buy gilts? For professional investors and advis e rs only 6 Chart 5: Institutional investors will still hold an historically small share of the market Source: DMO, Schroders. January 2012. Can this be done? In our estimation, the private non - financial sector will need to continue making a contribution to funding the UK government over the next five years, having already bought a significant amount of i ssuance in the previous five. This situation is eased, however, by some existing structural changes. Firstly, since 2007 we have seen overleveraged consumers look to pay down their debt and rebuild their balance sheets through increased saving . S overeign bonds, even with the low yields currently on offer, provide a convenient, liquid way of achieving this. With the deleveraging process in the UK still far from complete, the savings ratio is likely to remain elevated (relative to pre - crisis levels) over the next couple of years, underpinning demand for g ilts from the private sector. Over a longer - term horizon, but related to the increased savings rate, are the demographic pressures facing the UK. As the population ages, with a significant proportion of the p opulation at or near retirement age, the desire to move into low volatility fixed income securities increases, again providing support for the g ilt market. But are these two trends sufficient to induce the private sector to swallow another wave of bond i ssuance? Probably not. Over the medium - term, therefore, upward pressure on yields will be required to encourage price sensitive - buyers – the domestic private sector and institutional investors – to absorb the issuance. To be clear, this is not an argument that yields are likely to rise substantially over the short term, with ultra - loose monetary policy likely to keep the yield curve well pinned for the foreseeable future and a weak macro outlook maintaining the demand for duration. Nevertheless, th e supply and demand dynamics suggest that upward pressure on yields seems inevitable in the medium term. This need not be a harbinger of fiscal crisis, instead reflecting a more positive view on the UK’s economic prospects and the likelihood of tighter mon etary policy. With the need to source funding, and with a significant proportion of private wealth held by institutional investors, the lure of financial repression to policymakers is likely to remain strong. In its most passive form, this is likely to take the shape of persistent negative real yields on UK sovereign securities, even at the longer end of the yield curve. A more aggressive approach, such as legislating a minimum holding of g ilts in portfolios, would be more drastic, but it would be unwise to reject this a s a possibility going forward. Talking Point Who will buy gilts? For professional investors and advis e rs only 7 Important Information: The views and opinions contained herein are those of the Keith Wade and James Bilson , and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respec t. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to pr ovide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Info rmation herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fac t or opinion. This does not exclude or restrict any duty or liabi lity that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and th ese may change. Reliance sho uld not be placed on the views and information in the document when taking individual investment and/or strategic decisions . Issued by Schroder Investment Man agement Limited, 31 Gresham Street, London EC2V 7QA. Registration No. 1893220 England. Authorised and regulated by the Financial Services Authority.