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The Green Budget
Funding issues and debt management
January 2005
Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com
Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware
that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as
only a single factor in making their investment decision.
Overview:
Much more government debt is likely to be issued over the next five years than
over the last five. Demand from insurance and pension funds should be strong;
UK issuance is likely to remain below that of the largest euro area countries.
The Debt Management Office has pursued a simple, predictable and transparent
funding strategy, issuing debt across the maturity spectrum to achieve a relatively
smooth redemption profile.
There is a strong argument for the government to issue a much higher proportion
of long-dated and index-linked debt. The relative shortage of this sort of debt may
be keeping long rates unusually low.
The government might also find it attractive to become active in the options
market and to encourage the issuance of bonds linked to life expectancy. But
whether it should itself issue longevity bonds is much less clear.
Please refer to important disclosures at the end of this presentation
Public sector net borrowing
£ billion 2003-4 2004-5 2005-6 2006-7 2007-8 2008-09 2009-10
PBR 34.8 34.2 33.4 29.0 28.0 24.0 22.0
Base case 1 34.8 34.4 36.7 40.9 40.9 39.2 37.4
MS central 34.8 34.4 39.6 42.9 41.1 39.7 38.1
case
MS Sharp rise
34.8 34.4 49.2 65.0 73.6 80.7 88.5
in household
saving
1) Base case refers to IFS estimates based on PBR economic forecasts
Source: IFS, Morgan Stanley Research estimates, HM Treasury
Please refer to important disclosures at the end of this presentation
Public sector net debt
% of GDP 2003-4 2004-5 2005-6 2006-7 2007-8 2008-09 2009-10
PBR 32.9 34.3 35.4 36.2 36.8 37.0 37.1
Base case1 32.9 34.3 35.7 37.4 38.9 40.1 41.0
MS central 32.9 34.3 35.9 37.8 39.3 40.6 41.7
case
MS worse 32.9 34.3 36.7 40.4 44.3 48.4 54.5
case
(1) Base case refers to IFS estimates based on PBR economic forecasts
Source: IFS, Morgan Stanley Research estimates, HM Treasury
Please refer to important disclosures at the end of this presentation
Gilt issuance: the DMO’s Pre-Budget Report projections
£ billion 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10
Central Government 40 36 31 28 25 28
Net Cash
requirement1
Redemptions2 15 15 30 29 15 16
Financing 54 50 61 57 40 44
Requirement3
Illustrative Gross 50 48 59 55 38 42
Gilt Sales4
Notes: 2004-05 estimate of gross gilt sales is from the PBR; other projections assume national savings and investments run
at £2 billion a year and that other factors (e.g. changes in public sector net cash position and changes in the stock of Treasury
Bills) have zero net impact.
1, 2, 3: Source: DMO
4. Source: Morgan Stanley Research Estimates based on DMO projections
Please refer to important disclosures at the end of this presentation
Outlook for gross gilt issuance
£ billion 2004-5 2005-6 2006-7 2007-8 2008-09 2009-10
DMO/PBR 50 48 59 55 38 42
illustrative gilt
sales
Base case1 50 52 71 68 53 57
Morgan Stanley 50 54 73 68 54 58
central case
Morgan Stanley 50 64 95 101 95 109
worse case
1) Base case refers to IFS estimates based on PBR economic forecasts
Source: HM Treasury, IFS, Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Projections for net and gross debt issuance
100
Net gilt issuance
80
£ billions 60
40
20
0
-20
-40
1990-1 1992-3 1994-5 1996-7 1998-9 2000-1 2002-3 2004-5 2006-7 2008-9
120 Gross gilt issuance
100
80
£ billions
60
40
20
0
1990-1 1992-3 1994-5 1996-7 1998-9 2000-1 2002-3 2004-5 2006-7 2008-9
Past actual PBR/DMO
Base case 1 Morgan Stanley central case
Morgan Stanley weaker near-term
1) Base case refers to IFS estimates based on PBR economic forecasts
Source: IFS, Morgan Stanley and DMO
Please refer to important disclosures at the end of this presentation
The Scale of Gilt Issuance:
The projections are based on an assumption of no change in tax rates and
spending plans – so they exaggerate the likely scale of gilt issuance.
But more debt is likely.
It is helpful to put that in the context of demand from UK institutions and with
an eye on the size of bond issues from other European governments.
Please refer to important disclosures at the end of this presentation
The Scale of Gilt Issuance:
UK insurance companies and pension funds hold gilts with a market
value of around £220 billion – almost two-thirds of all outstanding gilts.
These bonds make up around 14% of the financial assets held by
pension funds and insurance companies
On the basis of our projections, net new issues of gilts over the next few
years will average somewhere around £40 billion a year. This would be
about 2.5% of the gross financial assets of UK insurance companies and
pension funds.
If there were to be no growth at all in the overall assets of insurance
companies and pension funds and if such institutions were to buy all net
new gilt issues – both extreme assumptions – their holdings of gilts
would rise from around 14% of all their assets today to between 19%
and 21% by 2007–08.
Please refer to important disclosures at the end of this presentation
EMU4 government bond issuance
700 Gross Issuance EUR bn
Redemptions
600
Net Issuance
500
400
Billion euros
300
200
100
0
E = Morgan Stanley Research estimates
Source: National Treasuries, Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
EMU 4: Government Bond Issuance, 1999-2010e
1999 2000 2001 2002 2003 2004 2005e 2006e 2007e 2008e 2009e 2010e
Across Countries
Germany 100 101 97 142 154 154 157 166 177 194 196 192
France 81 90 90 101 118 122 111 132 110 123 144 114
205 157 183 194 214 190 168 166 193 177 222 191
Italy
38 32 35 35 34 38 38 28 24 25 37 32
Spain
Gross Issuance 423 380 405 472 520 504 475 492 503 518 599 529
Redemptions 271 270 309 332 388 340 338 363 364 367 436 357
Net Issuance 152 110 97 140 133 165 137 128 139 151 164 172
E = Morgan Stanley Research estimates
Source: National Treasuries, Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Optimal Debt Management:
At present, the remit from the government to the Debt
Management Office (DMO) is that it should seek ‘To minimise
over the long term the costs of meeting the Government’s
financing needs, taking into account risk, whilst ensuring that
debt management policy is consistent with the aims of monetary
policy’
To meet this remit, the DMO has pursued a relatively simple,
predictable and transparent funding strategy that has not
explicitly involved targeting issuance at types of debt where there
appears to be strongest demand. Gilts have been issued across
the maturity spectrum and with an aim that there is a relatively
smooth redemption profile. There has been little use of
derivatives.
Please refer to important disclosures at the end of this presentation
Average lives of stocks of government debt
13
US Treasuries Gilts Euroland Governments
12
11
10
years
9
8
7
6
Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05
Source: Thomson Financial
Please refer to important disclosures at the end of this presentation
Composition of outstanding gilts 1999-2004
At end-March 1999 2000 2001 2002 2003 2004
Conventional
0-3 years 16 17 17 18 16 16
3-7 years 22 22 22 18 19 19
7-15 years 24 19 16 17 18 19
Over 15 years 15 16 17 20 19 21
Total 76 75 73 73 73 74
Index-linked* 21 23 25 26 27 25
Undated 1 1 1 1 1 1
Floating rate 1 1 1 0 0 0
* including index-linked uplift;
Source: DMO
Please refer to important disclosures at the end of this presentation
Debt Management:
On risk grounds there is a strong argument for the government
issuing long debt and with a high proportion in index linked terms.
This is probably what the optimal tax smoothing policy looks like
(Barro).
Fortunately there is no conflict with the aim of minimising expected
cost since long gilts look expensive (to buy) and cheap (to sell).
Please refer to important disclosures at the end of this presentation
Real yields on 20 year UK government index linked bonds
1986 3.95 1991 4.49 1996 3.62 2001 2.31
1987 4.16 1992 3.85 1997 3.05 2002 2.13
1988 3.97 1993 3.01 1998 2.05 2003 2.01
1989 3.80 1994 3.87 1999 1.86 2004 1.50
1990 4.38 1995 3.56 2000 1.89
Source: Bank of England estimated real spot yield curve (end year levels of yield)
Please refer to important disclosures at the end of this presentation
Long dated real and nominal yields
10
9 30 yr Nominal Gilt Rates
8 Long Dated Real Gilt Rates
7
Yield (%)
6
5
4
3
2
1
0
Dec-92 Aug-94 Mar-96 Nov-97 Jul-99 Feb-01 Oct-02 Jun-04
Date
Source: FinCad/Reuters
Please refer to important disclosures at the end of this presentation
Forward rate on euro and sterling government bonds:
December 2004
5.5%
5.0% EUR 6M forwards
4.5%
Rate (%)
4.0%
GBP 6M forwards
3.5%
3.0%
2.5%
2.0%
Dec-2004 Nov-2015 Oct-2026 Oct-2037 Sep-2048
Source: FinCad/Reuters
Please refer to important disclosures at the end of this presentation
GBP and EUR 15year ahead 15year forward Rates
8 8
GBP, annualised
EUR (DEM pre-EMU)
7 7
% rate
6 6
5 5
4 4
Jun-97 Feb-99 Nov-00 Aug-02 Apr-04
Source: Morgan Stanley
Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
If it were able to provide liquidity to the long-dated options market by
issuing calls or swaptions (an option to enter into a swap transaction),
government could be smoothing the costs of its own funding.
A call, or a swaption that gives the holder the right to receive a flow of
fixed-rate payments at some point in the future, is an instrument whose
value to the holder rises the lower are interest rates on bonds.
The issuer of such options receives a premium and then only faces a
future cost if bond yields fall below some given level in the future.
Government would be issuing securities whose net profits are positively
linked to the cost of its own future debt issuance, which is likely to be a
risk-reducing strategy.
It would help in hedging fix rate mortgages and generate securities in
short supply for those seeking long bonds ultimately backed by real
assets.
Please refer to important disclosures at the end of this presentation
Sample Contract Terms — Indicative 10yr – 20yr
Swaption Terms
Option Buyer: Counterparty
Option Seller: HM Treasury
Trade Date: 11 Jan 2005
Option Maturity 11 Jan 2015
Swap Maturity 11 Jan 2035
Strike: At The Money (4.475%)
Notional: £1,000,000,000
Option Type: European Receiver
Upfront Premium: £55,340,000
Current forward starting swap rate (10yr – 20yr): 4.475%
Breakeven swap rate: 3.85%
i.e. as long as the 20yr swap rate in 10 years time remains at or above 3.85% HM Treasury will not face any
net all-in expense.
Source: Morgan Stanley
Please refer to important disclosures at the end of this presentation
20yr historical GBP swap rate
6.5
6.0
5.5
Yield (%)
5.0
4.5
4.0 breakeven swap rate
3.5
Jan-99 Jan-00 Dec-00 Dec-01 Nov-02 Nov-03 Oct-04
Source: FinCad/Reuters
Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
Willetts (2004) and King (2004) have argued that there is likely to
be a role for the government in providing longevity bonds.
Is the government already substantially exposed to longevity risk
so that if life expectancy rises in an unanticipated way, its fiscal
position worsens because pressure on spending rises relative to
tax revenues? This is an issue that the tax-smoothing arguments
of Barro suggest is crucial.
Is the scope to spread longevity risk across different cohorts alive
at the same time (something that private financial markets can do)
so limited that the greater part of risks have to be handled by
government if they are to be spread much more evenly?
Please refer to important disclosures at the end of this presentation
Use of New Instruments? Options and Longevity Bonds
The UK government relies much more on taxes on labour income than
on taxes on capital income and spends a large amount on healthcare; it
also has substantial obligations to pay public sector pensions. This
suggests vulnerability to increase in life expectancy if that raises the
proportion of time people spend out of employment and raises the
demands upon the health system.
While the ability of financial markets to spread longevity risk across the
population is limited to those alive, this still presents scope to spread risk
much more widely than it now is. Currently, much longevity risk is
concentrated in particular places.
Risk sharing between the relatively old and the relatively young is
potentially highly advantageous. In principle, it can be achieved through
trading in financial markets.
Please refer to important disclosures at the end of this presentation
Use of New Instruments? Policies
There are a number of areas where the government could
potentially provide assistance to get a private market in longevity
bonds going:
At the moment, there are estimates from the Government
Actuary’s Department (GAD) on life expectancy, but these are
updated relatively infrequently. They have also in the past
severely underestimated longevity.
The Financial Services Authority could consider a policy of
allowing for regulatory capital relief to those who have exposure to
longevity risk but hold longevity bonds to hedge it.
Pension Protection Fund relief could be provided for funds that
hedged their mortality risks.
Please refer to important disclosures at the end of this presentation
Disclaimers
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Coverage Universe Investment Banking Clients (IBC)
% of % of % of Rating
Stock Rating Category Count Total Count Total IBC Category
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