Markets: Gilt squeeze leaves a hole at the long end

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The Independent Online
You don't often come across investors complaining that a country they invest in isn't borrowing enough. But that is exactly what's beginning to happen in the gilt market.

The much-improved state of British government finances has paved the way for the UK to slash the amount of bonds it needs to sell to fill the gap between what it spends and what it raises. That is leaving British investment funds starved of the securities they need to hold in their portfolios to match their liabilities, at a time when they are skittish about the stock market and looking to spread risk into different asset classes.

What's more, the hole at the long-dated end of the gilt market is likely to get bigger. "There is a shortage of stock, and with the amounts that are going to be supplied to the market in future, that shortage is likely to continue," says Tony Turner, manager at Norwich Union Investment Management.

Earlier this month the Bank of England scaled back its planned sales of new gilts in the coming months, after the Government cut its borrowing forecasts in its interim budget on 2 June. The Treasury lowered its budget deficit forecast for 1997-98 to pounds 13.25bn from pounds 19.2bn. It also cut its deficit forecast for 1998-99, targeting a shortfall of pounds 5.5bn from an initial forecast of pounds 12bn.

The Bank of England responded by scrapping two planned gilt auctions and trimming the size of some of its remaining bond sales. It intends to raise just pounds 16.5bn by selling gilts between now and March next year, using the proceeds to fund the Government's deficit needs and to repay maturing debt.

That means no new 30-year benchmark bonds in the gilt market, leaving the 8 per cent 2021 issue as the longest-dated conventional bond in the gilt market. "The reason we're not getting a new 30-year is that they'd never be able to get to a sufficient size with the current public borrowing outlook," says Philip Laing, manager at Scottish Life. "The alternative is to supply the 2021s, and there's a premium on that issue already."

The yield on 2021 gilts has fallen to a record low of 6.91 per cent this month, driven down both by expectations that UK inflation will remain low and buying by UK funds who have to hold long-dated securities to match the pension liabilities they are committed to paying out in the years ahead.

"The 2021 will stay the longest bond, and that is where you'll see forced buyers," says Colin Reedie, a fund manager at Scottish Amicable Investment Managers. "That bond is going to be pretty well underpinned by domestic institutions." The bank plans to sell an additional pounds 2bn of the bond this week to boost its total size to pounds 15bn.

Analysts say, however, that the planned introduction of a so-called "Strips" market later this year, which allows the interest and principal payments of a bond to trade separately, is likely to stifle how freely investors can buy and sell that bond.

The squeeze on government bond supply comes at a time when UK investors, who have typically put more of their money into stocks than bonds, are trying to shift more cash into fixed-interest instruments. A Merrill Lynch survey of 56 UK funds showed that buyers of gilts outnumbered sellers by 29 percentage points, the largest gap shown by the survey since December 1994. Sellers of UK equities outnumbered buyers by 18 points, a one-year high for the survey.

Concerns that rising official interest rates will squeeze company profits, and over the abolition of a tax credit on dividends paid to equity funds, are driving investors out of stocks and into bonds, Merrill says. "For pension funds, gilts are much more attractive, when compared to UK equities, than a month ago," says Merrill's global strategist Bijal Shah.

There is a plus to this position where a squeeze in gilt supply coincides with renewed investor appetite for bonds. It creates an opportunity for companies willing to sell sterling bonds with maturities of 10 years or more to stock up on cheap funding, and a couple of them have taken advantage of the window. Equitable Life borrowed pounds 350m last week by selling bonds, and Robert Fleming tapped the market with a pounds 100m issue.

Trouble is, not enough companies are borrowing. "It should open up the horizon for companies to issue long-dated stock at relatively low yields, but I think companies are still averse to locking in at current rates," says Mr Turner of Norwich Union. "They seem to prefer to issue for five or 10 years, and then look to reissue when yields have fallen further."

Even with yields on long-dated sterling bonds close to record lows, investors say company treasurers are loath to commit to long-term borrowing for fear that borrowing costs will fall lower still, now that the bank has control of interest rates and is firmly pursuing an anti-inflation policy.

"We're constantly waiting for issuers to bring out long-dated sterling issues," says John Godley, manager at Guardian Asset Management. "We virtually buy everything we can. We would buy even if there wasn't this lack of supply on the gilt side, because we want higher-yielding instruments at the longer end."