DEBT MANAGEMENT REPORT 1996-97
Last year, the Treasury and the Bank of England took forward a series of changes designed to increase the efficiency and liquidity of the gilts market and enhance the overall efficiency of the UK`s financial system. The most notable changes were the introduction of an open gilt repo market, the publication of a gilt sales programme, the reform of the UK`s system for taxing gilts and bonds and preparations for a gilt strips market. These changes have been widely welcomed. The repo market has begun well, with the number of participants and volume of business increasing steadily. The extra predictability and transparency of the auction programme has been praised both by market-makers and investors alike. I look forward to the preparations for a successful start of the gilt strips market.
Against this background, this Report describes in detail how the Government plans to finance the Central Government Borrowing Requirement and refinance maturing debt in the coming financial year. It sets out the Government's remit to the Bank of England, including the calendar of gilt auctions the Bank will hold and an indication the maturity of stocks which we intend to issue. It discusses the Government`s intentions for the index-linked gilts market and preparations for the launch of the strips market. Alongside these plans, the Report also contains the Government's assumption for sales of National Savings investment products. National Savings continues to make an important contribution to the Government`s financing.
My aim throughout the management of our funding has been to give market participants and investors as much information and input into the process as possible whilst maintaining the flexibility that any Government borrowing programme requires. This Report is a further demonstration of this Government`s commitment to a transparent borrowing programme and will be welcomed by all those involved.
27 March 1996
This is the second in an annual series of reports published by the Treasury designed to review developments in the gilts market over the past financial year and set out the Government's borrowing plans for the forthcoming year. This Report also reflects the recommendations of the Report of the Debt Management Review, published jointly by the Treasury and the Bank of England in July 1995.
This Report complements the detailed annual review of developments in the gilts market published by the Bank of England each June. It covers the following areas:·
The total outstanding UK Central Government marketable sterling debt was £273.2 billion at the end of February 1996. This comprised £212.7 billion of conventional gilt-edged stock, £46.2 billion of index-linked gilts (including accrued inflation uplift) and £14.3 billion of Treasury Bills (see Table 1). In addition, £56.2 billion (including accrued interest) was invested in National Savings instruments at the end of February.
Chart 1 compares the composition of the Government's debt portfolio at the beginning and end of the 1995-96 financial year, and the projected composition for the end of 1996-97 assuming that new debt is issued in accordance with the financing requirement and issue remit, and taking account of the aging of existing stock. The average maturity of the stock of all dated gilts fell slightly from 10.1 years in March 1995 to 9.7 years in March 1996, while the average maturity of conventional gilts fell from 9.0 to 8.7 years. The modified duration of the whole gilt portfolio fell from 6.24 years to 6.07 years over the same period, while that for conventional gilts alone fell from 5.30 years to 5.17 years. The maturity of the UK Government's own-currency debt remains among the longest of OECD countries. Table 2 shows the sectoral composition of gilts holdings at the end of March 1995.
Table 1Composition of UK Government MarketableSterling Debt (£ billion, nominal value, including official holdings) |
End March End Feb
1995 1996
Conventional Gilts 192.9 212.7
(Note 1)
Index - Linked Gilts 39.6 46.2
(Note 2)
Treasury Bills 9.0 14.3
241.5 273.2
National Savings 51.8 56.2
|
Note 1: Includes Floating Rate Gilt and undatedNote 2: Includes accrued uplift for RPI inflation |
Gross central government debt interest payments are forecast to be £25.1 billion in 1995-96, approximately 8.4% of total central government current expenditure. This figure is expected to rise to £26.5 billion (8.7%) in 1996-97.
In last year's review of debt management the Government restated the objectives of debt management policy to reflect current practice more accurately.
"The objective of debt management policy is to minimise over the long term the cost of meeting the Government's financing needs, taking account of risk, whilst ensuring that debt management policy is consistent with monetary policy."
This objective is addressed by the determination of an optimal issuance strategy reflecting the size and maturity structure of the existing and prospective stock of debt. The work takes account of a number of considerations, including:·
This exercise is carried out annually.
Table 2#Distribution of Holdings of Gilts at end-March 1995 |
£ bn. % of total
Non-bank Private Sector 167.9 72.2
Overseas Sector 35.1 15.1
Monetary Sector 20.5 8.8
Public Sector and Official 8.9 3.8
Holdings
232.5 100.0*
|
|
# Includes accrued uplift on index-linked gilts |
Gilt yields fell for most of 1995-96. The yield on the ten year benchmark fell from about 8.5% at end-March 1995 to a low of 7.3% in January before returning to about 8%. Yields fell furthest at the short end, where the reduction in base rates was a supportive influence. A differential of some 100 basis points between 5 and 20 year yields emerged during the year. (See Chart 2.)
The trend in the gilt market was associated with a decline in yields in other major international bond markets against a background of falling inflation expectations. This has been followed by a rise in international bond yields since the turn of the year.
The differential at the ten-year maturity over US Treasury bonds rose from about 130 bp at the start of the year to highs of over 200 bp in June and October (when the US yield fell to 6%). Since end-October the yield differential has narrowed to an average of around 180 bp. The differential (in semi-annual yields) against German bunds rose modestly during the first half of the year from 140bp to about 165 bp, and has since averaged around 160 bp.
Table 3The 1995-96 PSBR Funding Requirement (£ billion) |
Original Summer Budget
Remit Forecast Forecast
PSBR Forecast 21.5 23.6 29.0
Expected net change in the 0.0 0.0 0.0
Official Reserves
Expected Gilt Redemptions 4.1 4.1 4.1
Under/Overfund from 1994-95 (Note 1) * 1.6 1.4
Funding 25.6 29.3 34.6
Requirement
Funded
by:
Assumed net National Savings 2.5 2.5 3.0
inflow
Expected net sales of other public 0.0 0.2 0.5
debt
Gilt sales required for full funding 23.1 26.6 31.1
|
Note 1: Overfunding outturn only known after the original remit was published |
The remit published in March 1995 projected total gilt sales, including gilt redemptions, of £23.1 billion, based on a PSBR forecast of £21.5 billion in the November 1994 Budget and an assumed contribution of £2.5 billion from National Savings. The revised PSBR projection in the Summer Forecast was £23.6 billion, and after adjustments to minor components in the funding arithmetic, the total gilt sales required for a full fund was revised up to £26.6 billion. As a result of lower than forecast growth in tax revenues, the November 1995 Budget revised the PSBR projection up to £29.0 billion and the required total of gilt sales to £31.1 billion (see Table 3).
Total gilt sales are expected to be approximately £30.7 billion by the end of March.
The 1995-96 remit contained, for the first time, dates for the eight auctions to be held in the year. In order to meet the need for increased gilt sales on account of the higher than forecast PSBR, an additional auction was inserted into the programme in February 1996. The remit guideline for auction size was adhered to.
The remit stated that approximately 15% of gilt sales would be of index-linked stock, and that conventional issuance would be spread approximately evenly between the short, medium and long maturity bands, and that conventional taps would be used only as a market management tool. The maturity composition of the debt issued during the year reflected the remit (see Chart 3).
Table 4Results of Gilts Auctions held in 1995-96 |
Stock Amount of issue Date of auction Lowest Average Highest Times Tail Title (£ billion) Yield Yield Yield Covered (basis points) 8% 2000 2.0 26-April-1995 8.29 8.30 8.30 2.17 0 8½% 2005 2.5 29-June-1995 8.41 8.42 8.42 2.00 0 8% 2015 2.5 26-July-1995 8.33 8.33 8.34 1.42 1 7½% 2006 3.0 27-September-1995 7.99 8.02 8.09 0.99 7 8% 2015 3.0 25-October-1995 8.33 8.33 8.33 2.00 0 7½% 2006 3.0 06-December-1995 7.40 7.45 7.56 1.12 11 8% 2000 3.0 31-January-1996 6.70 6.74 6.76 1.96 2 8% 2021 3.0 28-February-1996 8.06 8.09 8.14 1.48 5 7% 2001 3.0 27-March-1996 n/a n/a n/a n/a n/a |
Two new stocks, both of them strippable upon the commencement of the official strips facility, were created in 1995-96; a new 10 year benchmark (7½% Treasury Stock 2006) created in September and re-opened in December, and a 25 year ultra-long (8% Treasury Stock 2021) created in February 1996. Results of auctions held to end-February are shown in Table 4.
The outstanding balance of National Savings instruments at the start of the financial year was £51.8 billion. The funding assumption for National Savings set out in the 1995-96 Debt Management Report was £2.5 billion. This was subsequently revised up to £3.0 billion in November. National Savings net contribution up to the end of February was £4.4 billion, including accrued interest. Net funding for the year to end-March 1996 is expected to be around £5 billion, and gross funding (i.e. including refinancing of withdrawals) is expected to be around £11.3 billion. The main contributors were Pensioners' Guaranteed Income Bonds (following the reduction in the qualifying age limit from 65 to 60 and increase in the holding limit announced in the Budget) and Premium Bonds. The change in the composition of outstanding products is shown in Table 5.
In order to keep the cost of funding through National Savings comparable with gilts, interest rate reductions of between 0.25% and 1.1% on various National Savings products were made in January, to reflect the fall in short-term interest rates and gilt yields.
It was announced in early March that the Department for National Savings would become an Executive Agency from 1st July 1996. it will continue in its rôle of providing attractive savings products and playing a substantial part in the funding programme.
Table 5Change in National Savings Products Outstanding (1995-96) |
End Mar 1995 End Feb 1996*
£ billion % £ billion %
Variable 27.9 53.9 29.0 51.6
Rate
Fixed Rate 15.7 30.3 18.5 32.9
Index-Linked 8.2 15.8 8.7 15.5
51.8 100.0 56.2 100.0
|
* Provisional figures |
1995-96 witnessed further extensive steps designed to enhance the efficiency of the gilts market.
A number of steps were taken in 1995 to increase the predictability and transparency of debt management. The Government Funding Remit to the Bank of England contained in the first Debt Management Report, published in March 1995, supplied more detailed information on the annual borrowing programme than had been released before, including estimates of the funding contribution from National Savings, a breakdown of the planned maturity structure of gilt issues and a calendar of gilt auction dates for the coming year. This approach was continued with the joint publication by HM Treasury and the Bank of England of the Report of the Debt Management Review (DMR.) This·
Detailed plans for an open gilt repo market were published by the Bank of England at the end of March 1995. During the remainder of the year, the necessary administrative, legal and settlement-related measures were completed, including a code of best practice, and the open gilt repo market commenced on 2 January 1996. The market has operated smoothly and thus far turnover has steadily increased. A gilt repo consists of a cash sale together with an agreement to repurchase the same stock at an agreed price at a fixed future date, or at call. Repo improves liquidity and arbitrage opportunities in the market by allowing participants to finance long positions by borrowing cash against gilts as collateral, as well as borrowing stock to cover short positions.
The introduction of the repo market and preparation for establishing a gilt strips facility have been accompanied by a major rationalisation of the taxation of gilts, and of tradeable debt securities in general. These changes were necessary for the establishment of the repo and strips markets; they also aim for fiscal neutrality in the field of corporate financing generally, and have been widely welcomed by the markets and professional bodies.
The introduction of an open gilt repo market required major reforms to the withholding tax system for gilts, implemented in the 1995 Finance Act. Since January 1996 most large investors have been able to elect to receive coupons gross of tax, with UK corporate holders accounting for tax purposes on a quarterly basis. The distinction between FOTRA (free of tax to residents abroad) and non-FOTRA gilts is now largely irrelevant for trading purposes. The requirement for overseas holders to have the intention of holding stock over two or more successive dividend dates before receiving gross payment has also been removed.
Under the current tax system gilt interest payments are generally taxed on a "when paid" basis as income, while capital gains and losses are untaxed and unrelieved. On May 25 1995, the Inland Revenue announced that it was consulting on fundamental reforms to the tax regime for bonds generally, and on 10 July the Chancellor announced the Government's intention to align the tax system with normal accounting practice, and hence remove the often artificial distinction between income and capital gain. Holdings of gilts (as well as all other corporate and commercial debt by corporates) will be taxed on a total returns (income and capital) basis, with relief allowed on capital losses. The neccesary provisions have been included in the 1996 Finance Bill currently before Parliament.
Firms will be able to account on either a mark-to-market or an accruals basis, both techniques widely used for non-taxation accounting purposes, instead of having to prepare figures solely for tax assessment as has often been the case in the past. Gilts held by individuals and trusts will continue to be taxed on interest payments only, as before. Two low coupon gilts (3½% Funding Stock 1999/2004 and 5½% Treasury Loan 2008/2012) which are widely held by individual investors, will also remain outside the new system.
Besides bringing about a welcome simplification of the tax code, the abolition of the income/capital gain divide in tax legislation will allow for the development of a number of non-standard debt instruments, including gilt strips. More generally, the reforms have reduced tax-induced anomalies in gilt yields. They should therefore promote more efficient pricing, and greater liquidity in the market. The new provisions will take effect from April 1996.
In parallel with the Inland Revenue consultation about the new tax system, the Bank consulted the market about an official gilt stripping facility. The response was enthusiastic and subsequent consultation on the Bank's detailed plans earlier this year has indicated that it remains so.
The gilt strips facility is expected to commence during the first half of 1997. Preparations are on course to achieve this, but a considerable amount of work remains to be done. The necessary changes in the tax treatment of gilts were included in the 1996 Finance Bill. It is likely that new Government stock regulations, as well as minor and consequential amendments to the legislation, will be required. Consultation on these regulations will be carried out by the Autumn. Work is also continuing on the update of the Central Gilts Office settlement system, which will include new software to facilitate the operation of the strips market.
The market will require a large amount of initial liquidity to ensure that it is attractive to investors. In September it was announced that the three current benchmark stocks (8% Treasury Stock 2000, 8½% Treasury Stock 2005 and 8% Treasury Stock 2015) as well as the new stock to be auctioned later that month (7½% Treasury Stock 2006) would be strippable on the commencement of the strips facility. In addition, £3 billion of a new strippable 2021 stock was created in February. These stocks have a total of some £35 billion outstanding that will be strippable when the market starts, all with coupon dates aligned on 7 June and 7 December (See Table 6.)
To build up liquidity further the authorities' intention is that future medium and long maturity benchmark issues should be strippable. There is clear demand for this and it is the practice in other markets. The strippability of any future short-dated benchmark issues will be kept under review in the light of demand and liquidity.In addition, the Bank of England may from time to time make offers for the conversion of unstrippable stocks into strippable ones of similar maturity. Any programme of conversion offers is unlikely to be extensive.Further details will be announced in due course, in the light of market conditions.
Table 6Stocks Declared Strippable upon commencement ofOfficial Strips Facility Nominal Amounts in Issue at end March 1996 (Projection) |
Stock Title Amount Issued
(£billion)
8% 2000 7.8
8½% 2005 8.9
7½% 2006 6.0
8% 2015 9.5
8% 2021 3.0
Total 35.2
|
The 1995-96 Remit set a target for index-linked gilt sales of approximately 15% of total gilt issues. With index-linked sales expected to be around £4.5 billion (cash) in 1995-96, this target will be almost exactly met.
The Debt Management Review set out the benefits of having index-linked gilts in the Government's debt portfolio. It noted, however, that the market for them tended to be less liquid than for conventional gilts. It concluded that investors, market-makers and the Government would benefit from greater liquidity.
Following on from the Review, the Bank of England hosted a conference in September 1995 for market participants, academics and sovereign issuers to discuss the role of indexed debt in government portfolios, the scope for developing the market and extracting information from indexed bond yields. The Bank announced that, following the conference, the authorities had no current plans to issue other forms of indexed debt (eg. earnings-linked or 'Limited Price Indexed') or to move to benchmark index-linked gilt issues. It was also announced that the Bank would consult with market-makers and end-investors further on the questions of whether and how to hold index-linked gilts auctions and establish a separate index-linked market-maker list.
The authorities have considered carefully the results of this subsequent consultation. The authorities recognise the long-term benefits to liquidity that index-linked auctions and separate market-makers could bring. However, the prospect of auctions did concern many end-investors and the caution of many of the market-makers most likely to be involved in an auction process indicated that a pilot programme would be risky at this stage of the market's development. Also, there are indications that liquidity in the market, as measured by the spreads quoted for a given size of transaction, has improved in the past year due to the greater market-maker activity and continued sales. Consequently, the Government has decided not to hold an index-linked auction experiment in 1996-97 but will keep under review the possibility of holding such auctions in future years. A separate market-maker list will not be established in 1996-97.
The target level of index-linked sales for 1996-97 will remain at approximately 15% of total gilt sales. On the current financing arithmetic, this target implies that the authorities will aim to sell around £4.9 billion (cash) of index-linked gilts in 1996-97, similar to the level in 1995-96.
The Debt Management Review confirmed auctions as the primary means of conventional gilt sales as part of progression to more predictable issuance.
In the light of the importance of the auction mechanism, the authorities have kept its performance under review and explored with the market a number of possibilities for improving its operation. This consultation has taken place against the background of the increased variability in auction results in 1995-96. The review has included uniform price auctions (see box), dual stock auctions, the size of non-competitive bids, and the timing of auctions.
|
The Debt Management Review discussed the possibility of the UK authorities holding a uniform price auction experiment in the light of the results of the US Treasury experiment with a uniform price format and consultation with the market. The results of the experiment have now been analysed. The US Treasury found that the uniform price allocation generally widened participation at bond auctions and may have resulted in higher revenue for the issuer. However, this increase was found to be marginal and statistically insignificant whilst the volatility of auction results increased. Consequently, although there are theoretical arguments in favour of the uniform price format, these have been only partially realised in the US experiment. The views of gilts market participants were mixed, with some end-investors saying that a uniform price allocation might increase their participation in the auction process whilst market-makers as a whole indicated that it could lead to their materially scaling back their bidding. Given that the results of the experiment and consultation have been inconclusive, the UK authorities do not have any current plans to conduct a uniform price experiment in the conventional gilt auction programme.
|
The authorities have decided to make the following changes to the auction mechanism in 1996-97·
The Debt Management Review announced the Government's decision to replace the "funding rule" with a new framework for financing which will continue to provide the necessary discipline to ensure a prudent maturity structure for debt issuance and the underlying debt stock. From 1996-97 onwards the objective will be to sell sufficient gilts of any maturity, Treasury Bills and National Savings products to finance the Central Government Borrowing Requirement (CGBR), plus maturing gilts and any net increase in the foreign exchange reserves. All such debt issuance will take place within a set maturity structure to be determined each year and published before the start of the year in the Debt Management Report. The Government has no plans to make significantly greater use than at present of short term debt issuance.
Table 7 gives full details of the debt instruments the Government intends to use to finance the CGBR in 1996-97, on the basis of the 1995 Budget forecasts for CGBR and maturing gilts. As shown in the table, the Government does not intend to use any marketable debt instruments of less than 3 year maturity to finance the 1996-97 CGBR.
As a transitional measure, to maintain consistency with the old funding rule in its last year of operation, any over- or underfund, calculated on the previous basis, in 1995-96 will be carried forward and added to the amount of gilts of over 3 year maturity to be sold in 1996-97.
Table7The 1996-97 Financing Requirement |
£ billion
CGBR Forecast 24.1
Expected net change in the Official 0.0
Reserves
Gilt Redemptions 11.5
Under/Overfund from 1995-96 *
Financing Requirement 35.6
Less net financing from:
Department for National Savings 3.0
Certificates of Tax Deposit (Note 1) 0.0
Remaining debt sales required 32.6
Made up by net sales of:
Treasury Bills and other short term debt 0.0
(Note 2)
and gross sales of:
Ultra-short Conventional Gilts (1-3 years) 0.0
Short Conventional Gilts (3-7 years) 9.2
Medium Conventional Gilts (7-15) years) 9.2
Long Conventional Gilts (15+ years) 9.2
Index-Linked Gilts 4.9
|
* Under/Over funding outturn from 1995-96
is not yet known
|
.+ This auction date will depend on the timing of the Budget.These auction dates may be altered to avoid data releases or monthly monetary policy meetings between the Chancellor and the Governor of the Bank of England.