Rosy outlook for gilts dealers: Peter Rodgers finds a group of people delighted with the continuing revival in government stock

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A SMALL band of people in the City is delighted that the Government will have to borrow pounds 1bn a week over the next year to plug the growing hole in its finances.

They are the 250 or so dealers and sales specialists employed by the 19 gilts market-making firms through which all the Government's funding is channelled.

From an apparently dead-end job in the late 1980s, dealers in government stock are now an elite band, many on pounds 100,000 a year and above. Moreover, their future looks assured with no sign that the Government will be able to get its finances in order until near the end of the century.

Not long ago some economists were saying the Government would have a permanent financial surplus with no need to borrow. The gilts market would become a backwater as its dealers, already noticeably more mature than many other City specialists, grew into a quiet middle age.

But the determination of those firms that stayed in the market despite a poor outlook and heavy losses now looks set to pay off, benefiting owners and staff, whose earnings include substantial profit-related bonuses.

Their persistence will also help the Bank of England, whose officials have spent an anxious six and a half years since Big Bang nurturing the gilts market.

As a result Mike Higgins, head of gilts at Greenwell Montagu Gilt-Edged, part of Midland, can say: 'Our capital is adequate for any position we have wanted to take and I think that is true of the whole market.' John Mernagh, head gilt salesman at BZW, says: 'We are pretty relaxed about the market's ability to respond.'

Which is just as well. The value of gilts in issue could double in the next three years to more than pounds 300bn.

In the financial year to March new issues will rise to about pounds 35bn, twice their amount in 1991- 92. In the year from April they could soar as high as pounds 55bn, substantially exceeding the borrowing requirement because of the need to sell new stock to replace old issues due for repayment.

In inflation-adjusted terms, however, government borrowing will still be a fifth less than during the worst economic crisis in recent memory, in the mid-1970s.

But that era provides little in the way of lessons for the present about how to cope. The markets have changed completely.

Abroad, capital has become more footloose than ever. Governments must now compete fiercely with each other and with big corporations for money.

Some market-makers firmly believe that they will find a home for the flood of new gilts among their existing institutional clients.

But others are highly critical of this laid-back attitude and want to see a more positive effort to find new buyers. 'Governments have to promote their bond markets more than ever before,' says the head of bond trading at a large securities firm. He says the claim that existing clients will buy in double quantities is 'bullshit'.

The Government is being urged to start marketing gilts abroad more systematically. One securities firm has suggested a roadshow in which senior officials and investment bankers would give presentations on the British economy in New York, Tokyo and other investment centres.

The Bank of England is likely to baulk at asking the Chancellor to sell gilts in person, but it has signalled that it is willing to look at ways to boost market-makers' efforts to find new buyers abroad. Perhaps Sir Terence Burns, the Treasury Permanent Secretary, should do the selling.

A separate technical proposal on the table is to allow gilts sales to be handled on international clearing systems such as Euroclear, which would make them easier to buy for some investors.

And the Bank is re-examining whether there should be a sale and repurchase market in gilts, which a number of international firms would like.

The other big change is inside the gilts market, where the Big Bang of October 1986 transformed trading.

Originally the market was split into jobbers, who made prices by taking government stock on to their own books, and brokers, who bought from the jobbers and dealt with clients on commission. Two jobbers, Akroyd & Smithers and Wedd Durlacher, did most of the market-making in a cosy relationship with the Bank.

Big Bang saw jobbers and brokers replaced by 29 dual function market-makers, combining broking and jobbing in a system based on a US model.

The first few years after Big Bang were a financial disaster for the firms that emerged, with net losses from October 1986 to the end of 1988 totalling pounds 190m.

But a combination of fewer market-makers, a tough attack on costs and the flood of gilts has transformed the picture since 1990.

The Bank of England is expected to reveal later this month that the gilts market-makers as a whole made a net profit in 1992 for the third year running, and it will exceed the pounds 49m in 1991.

A number of firms, including Warburg, were in the red in the first half of 1992. But the damage to the market-makers was more than repaired in the last quarter of the year in the hectic trading after Britain withdrew from the exchange rate mechanism.

No firm can rest on its laurels. Warburg and Greenwell Montagu are the biggest. Greenwell has about 15 per cent of the market, Warburg slightly more.

BZW, part of Barclays - and by far the most profitable firm in 1991 - Lehman Brothers, Salomon, UBS Phillips & Drew and Goldman Sachs are other leaders.

At the lower end of the scale are tiddlers and recent entrants such as Deutsche Bank. Two more firms, Yamaichi and possibly Merrill Lynch, which quit the market in 1989 after losing pounds 11m in three years, may be newcomers or re-entrants.

Market-makers are cottage industries, rarely employing more than a couple of dozen people. But the stakes and potential profits are high and rising, and pecking orders can change rapidly.

Market sources say Salomon, the US securities firm, has shot up to fourth and possibly third in market share over the past three months, putting it within spitting distance of Greenwell.

Others doubt whether it will stay as high for a whole year, but recent performance underlines Salomon's expertise at US-style bond auctions, which the Bank of England introduced experimentally in 1988 and which are now the main feature of its fund-raising.

Salomon has a reputation for bidding big quantities and taking large risks in its own name. The firm is scornful of less well capitalised or loss-making rivals who are urging the Bank of England not to increase the size of auctions to pounds 4bn or more from last week's bite-sized chunk of pounds 2.5bn.

The Bank is looking at whether the rules about capital could be tinkered with to cope with the surge of auction day.

Most of the big firms are confident they have the systems to handle a big increase in borrowing, despite a hiccup last autumn in dealing with orders for small investors.

Since average order sizes are expected to rise sharply, there is not likely to be a scramble for staff as funding rises, though experienced dealers are in demand.

Andy Tweed, head of gilts at BZW, says: 'The most competitive market we are in is the staffing market - we try to have the best staff and we want to keep them.'

The Bank of England keeps a close eye on personnel, and bans poaching of teams when new market-makers set up.

But the City perception that it is nannying the gilts market to ensure easy sales of government debt was undermined last week when interest rates were cut the day before the auction, inflicting losses on many market-makers.

The firms thought they had an informal understanding that rates would not change so near the auction. The Bank has now made it clear they were wrong.

This row could slow the bidding for a few months, since a smooth- running market is essential to an auction system.

But at the end of the day investors buy government bonds if the interest rate on the bond and the level of the currency in which it is denominated look right. And that depends on the Government, not the City.

(Photograph omitted)

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