Gilts suffer from tarnished image until proved otherwise When the gilt went 42 y

THERE were red faces at the Bank of England last week. The embarrassment was due not to any scandal involving the Governor's carpet, but to something rather more serious. For the first time since the Bank started using auctions in 1987 to sell the gilt-edged stocks that finance the Government's borrowing, it failed to shift the entire amount on auction.

Officials tried to make the best of the flop. Although admitting that the auction had been a disappointment, they pointed out that pounds 2.967bn of the pounds 3bn of gilts had been sold.

Gilts dealers in the City said this was only because the Bank had called in favours after it had seen the paltry initial bids for the stock, a medium-term gilt due for redemption in 2006, paying a coupon - or interest rate - of 7.5 per cent. And even so, the spread between the lowest price bid and the average, known as the tail, was unusually large. This meant that some investors were only buying at a very low price.

So what went wrong?

Several factors contributed. International markets had been unsettled during the previous week. Foreign interest in gilts has been at best lukewarm all year, partly because the main action has concerned the US, German and Japanese markets, and partly because of the weak pound.

The more important influence was the fact that domestic investors have begun to realise the Government might have to borrow much more than it planned this year. More borrowing means more gilts for sale, which makes investors price them lower.

How much more government borrowing will there be?

The Treasury's most up-to-date published estimate of the Public Sector Borrowing Requirement for the current financial year - the forecast the Bank of England has to operate with - was pounds 23.6bn. But the PSBR for April- August is higher than at the same stage last financial year - a year in which the Government had to borrow pounds 35.9bn.

Sales of gilts will have to fund most of the borrowing total, which City experts now think will be pounds 30bn to pounds 32bn in 1995-96. (National savings and extra gilts sold the previous year reduce the total required, while maturing gilt issues have to be refinanced and increase issuance.) Analysts think another pounds 18bn to pounds 22bn of gilts will have to be sold before the end of March.

Why are they sold through an auction?

Auctions were introduced in 1987, after the City's Big Bang. Most other countries use an auction system to sell government debt. The scheduled auctions are supplemented by smaller ''taps''.

For the past two years the Treasury has given the Bank a formal funding remit - or set of requirements for funding government debt in the forthcoming year. This has enabled the Bank to issue a schedule for auctions at the beginning of the year. Participants in the gilts market like the predictability - but it will prove embarrassing if the Bank needs to schedule an extra auction before the end of the financial year because of a borrowing overshoot.

Were there any other reasons for last week's auction result?

The Bank's choice of stock for the auction might have contributed. Many analysts expected it to be popular, because next year it will become the 10-year "benchmark" gilt, which will keep it in demand by institutional investors. In addition it will be ''strippable'', another characteristic investors like. But it turned out that funds had already bought enough stocks with these features and didn't want any more.


The Treasury has announcedtwo big reforms which will make the gilts market more attractive to overseas investors. This should eventually mean that the Government will pay a bit less interest on its debt.

The development of a gilts strip market was announced first. The coupon will be separated, or stripped, from the gilt-edged stock itself. There will be two kinds of government debt securities: the entitlement to repayment of principal and the entitlement to the stream of interest payments. Big investors prefer the flexibility of having two separate instruments. Gilts strips will go ahead in the second half of next year.

And the second big reform?

The introduction of a gilts repo market in January will be the biggest change. A repo is a sale and repurchase agreement. Holders of gilts can sell them for cash and buy them back at an agreed future price and date. The holder gets a loan using the gilt as security. The buyer of the repo gets a higher return with excellent collateral for the loan.

Will it make it any easier for the Bank of England to fund the Government's debt?

Eventually, yes, because the changes will attract new gilts investors. But the next 12 months could be volatile for the gilts market - especially if the PSBR does turn out to be way over target. The City vigilantes would punish an incautious Budget.

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