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					Green Budget: Funding Issues and Debt
Management
January 30th 2008
David Miles, Chief UK Economist
David.Miles@morganstanley.com
Laurence Mutkin, Head of European Interest Rate Strategy
Laurence.Mutkin@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.
Please see important disclosures at the end of this report.
Summary
 Government is again likely to borrow more than forecast.
  But the gilt issuance environment is still favourable as
  yields are very low.
 Yields on shorter dated gilts have fallen a lot. Issuance
  could now be less skewed towards longer dated bonds.
 One factor behind such low gilt yields is the “credit-
  crunch” – which, if it continues, poses significant
  difficulties for mortgage lenders.
 Mortgages where repayments are linked to consumer or
  house prices could be attractive and commercially viable.

             David Miles, David.Miles@morganstanley.com
             Laurence Mutkin, Laurence.Mutkin@morganstanley.com   2
The scale of gilt issuance




     David Miles, David.Miles@morganstanley.com
     Laurence Mutkin, Laurence.Mutkin@morganstanley.com   3
Table 6.3. Gilt issuance: the DMO‟s illustrative projections based
on Pre-Budget Report forecasts
£ billion                            2006–07 2007–08 2008–09 2009–10 2010–11 2011–12 2012–13
Central government net                 41.2        37.3         42*         38          33          34          29
cash requirement
Redemptions                            29.9        29.2         17          16          30          27          8
Financing requirement                  71.1        66.5         59          54          63          61          37
Other sources of financing*            –8.6*       –8.1         –6          –2          –2          –2          –2
Illustrative gross gilt sales          62.5        58.4         53          52          61          59          35
Notes: * The DMO announced on 24 January that the government would repay £4 billion of its ways and means
facility at the Bank of England. We assume that this £4 billion will be added to the central government net cash
requirement in 2008–09. We assume that this will be met entirely by non-gilt financing (e.g. Treasury bills). Other
projections assume national savings and investments run at £2 billion a year and that other factors (for example,
changes in the public sector net cash position and changes in the stock of Treasury bills) have zero net impact.
Sources: Debt Management Office; Morgan Stanley Research.


                     David Miles, David.Miles@morganstanley.com
                     Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                               4
Table 6.4. Outlook for gross gilt issuance
£ billion                                        2006– 2007– 2008– 2009– 2010– 2011– 2012–
                                                   07    08    09    10    11    12    13

DMO/PBR illustrative gilt sales                    62.5      58.4       53        52         61        59        35

IFS base case                                      62.5      60.3      58.8      62.4      71.9       67.4      43.3

MS central case                                    62.5      60.1      59.5      64.4      76.1       74.3      53.3

MS pessimistic case                                62.5      59.5      64.3      78.3      95.6       97.5      79.6
Note: The alternative projections in Table 6.4 to the DMO/PBR illustrations are not really forecasts of what gilt sales
would be since they are based on an assumption of unchanged spending plans and tax rates.
Sources: IFS; Morgan Stanley Research; HM Treasury.




                       David Miles, David.Miles@morganstanley.com
                       Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                                 5
Table 6.5. Gilt issuance and gilt yields
                                     Gross (Net)               15-year                     15-year
                                   issuance (£bn)            nominal yield                real yield
 2001–02                               14 (–5)                  4.86%                       2.37%
 2002–03                               26 (9)                   4.71%                       2.21%
 2003–04                               50 (29)                  4.70%                       2.04%
 2004–05                               50 (35)                  4.57%                       1.78%
 2005–06                               52 (38)                  4.24%                       1.44%
 2006–07                               63 (32)                  4.41%                       1.37%
 2007–08                               58 (29)                  4.75%                       1.50%
 28 Jan 2008                                                    4.5%                        1.0%
Notes: 15                                                                                           2007–08
         -year real and nominal yields are funding year averages of Bank of England estimated spot yields.
                                                11
estimates are calculated using spot yields up until January 2008.
Sources: Bank of England; Debt Management Office.




                    David Miles, David.Miles@morganstanley.com
                    Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                        6
Figure 6.4. Long term real interest rates on
UK conventional debt
              6%
                                  Average long-term real interest rates

              5%                  Long-term average (1700-2006)

              4%
 Real yield




              3%


              2%


              1%


              0%
                   1700- 1750- 1800- 1850- 1900- 1960- 1970- 1980- 1990- 2000- 2006                         2007
                   1749 1799 1849 1899 1939 1969 1979 1989 1999 2005
Notes: Nominal 2.5%consol rate less long                                      –
                                          -term inflation expectations. 194059 is omitted from the graph [but not
from the long-run average, which otherwise would rise further to just under 3.6%] because rationing during this period
                                          g
made price data unreliable, leading to a neative real long -term interest rate.
Source: Morgan Stanley Research. Estimates of real yields are based on the nominal yield on consols net of a
                                                                                                             ruct
measure of expected inflation over the coming 10 years. For a detailed description of the method used to const
the real yields, see D. Miles, M. Baker and V. Pillonca, „Where should long interest rates be today? A 300 year
                                                                            -term
view‟, Morgan Stanley Research, March 2005.

                    David Miles, David.Miles@morganstanley.com
                    Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                                   7
Figure 6.1. National debt as a proportion of national
income since 1855
                                300
                                        Government debt-to-GDP ratio
                                250
  Per cent of national income




                                200


                                150


                                100


                                 50


                                  0
                                      1855
                                      1860
                                      1865
                                      1870
                                      1875
                                      1880
                                      1885
                                      1890
                                      1895
                                      1900
                                      1905
                                      1910
                                      1915
                                      1920
                                      1925
                                      1930
                                      1935
                                      1940
                                      1945
                                      1950
                                      1955
                                      1960
                                      1965
                                      1970
                                      1975
                                      1980
                                      1985
                                      1990
                                      1995
                                      2000
                                      2005
                                      2010
Notes: Pre-1974 series is gross nominal liabilities of the National Loans Fund (formerly known as the national debt).
1974 onwards it is the general government gross debt.
Sources: Debt Management Office, HM Treasury, Office for National Statistics.




                                      David Miles, David.Miles@morganstanley.com
                                      Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                8
Issuance strategy




     David Miles, David.Miles@morganstanley.com
     Laurence Mutkin, Laurence.Mutkin@morganstanley.com   9
Table 6.6. Breakdown of gilt issuance by maturity and type
%                                  Conventional                                          Other
                      0–7          7–15          15+          Total       Floating Undated             Index-
                     years         years        years                                                  linked
2000–01               38.9          16.1         17.4          72.5          1.1           1.1          25.3
2001–02               36.7          17.0         19.5          73.2          0.0           1.2          25.6
2002–03               35.6          17.7         19.0          72.2          0.0           1.1          26.7
2003–04               34.3          18.6         21.0          73.9          0.0           1.0          25.1
2004–05               37.2          14.1         23.0          74.3          0.0           0.8          24.8
2005–06               32.8          15.4         25.2          73.5          0.0           0.7          25.8
2006–07                28            19            25           72           0.0            1            27
2007–08               17.2          17.1         40.0          74.3          0.0           0.0          25.7
Notes: Floating -rate gilts have coupons set in line with short -term interest rates. The redemption of undated gilts is at
the discretion of the government.
Source: Debt Management Office.




                    David Miles, David.Miles@morganstanley.com
                    Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                                        10
 Figure 6.9 The Gilt yield curve
  6.0

               UK 2Y

  5.5          UK 30Y




  5.0



  4.5



  4.0



  3.5
   Jan-05      Jul-05     Jan-06    Jul-06        Jan-07    Jul-07   Jan-08

   60.0
   40.0                                       UK 30Y-2Y
   20.0
    0.0
   -20.0
   -40.0
   -60.0
   -80.0
  -100.0
  -120.0
  -140.0
      Jan-05     Jul-05    Jan-06    Jul-06        Jan-07   Jul-07   Jan-08

 Source Morgan Stanley
David Miles, David.Miles@morganstanley.com
Laurence Mutkin, Laurence.Mutkin@morganstanley.com                            11
Figure 6.7 . 2-year gilt yield vs base rate (%)
        8.0
                                                                                                       BoE Base
                                                                                                       Rate
        7.0                                                                                            UK 2Y


        6.0


        5.0

              M P C est'd
        4.0


        3.0
         Jan-96        Jul-97       Jan-99     Jul-00      Jan-02       Jul-03      Jan-05       Jul-06      Jan-08

  1.5
  1.0
  0.5
  0.0
 -0.5
 -1.0
 -1.5
                                                                         UK 2Y - Base Rate
 -2.0
                      MPC est'd
 -2.5
   Jan-96         Jul-97          Jan-99     Jul-00      Jan-02       Jul-03       Jan-05       Jul-06       Jan-08




Notes: The upper panel shows the base rate and the 2 -year gilt yield; the lower panel shows the spread between the
two. When the market anticipates an official rate cut (shaded are as), the 2 -year yield trades below the base rate .
      David Miles, David.Miles@morganstanley.com
Source: Bloomberg .

      Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                                                12
Figure 6.10 30-year Index Linked real yield and
Break Even Inflation (BEI)
  4.5
                                                              UK 30Y BEI
  4.0
                                                              UK 30Y Real Yield

  3.5

  3.0

  2.5

  2.0

  1.5

  1.0

  0.5

  0.0
   Jan-97      Jul-98   Jan-00    Jul-01    Jan-03   Jul-04          Jan-06       Jul-07

 Source Bloomberg


        David Miles, David.Miles@morganstanley.com
        Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                 13
The credit crunch, funding
 issues and the mortgage
 market


     David Miles, David.Miles@morganstanley.com
     Laurence Mutkin, Laurence.Mutkin@morganstanley.com   14
Figure 6.5. Secured–unsecured spreads in the UK and Europe,
and the US Commercial Paper AA-A2/P2 spread

 160

 140             US 30-day A2/P2-AA
                 UK 3-month LIBOR-repo
 120
                 EU 3-month LIBOR-repo
 100

  80

  60

  40

  20

   0
   Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08
Source: Reuters EcoWin.



                    David Miles, David.Miles@morganstanley.com
                    Laurence Mutkin, Laurence.Mutkin@morganstanley.com            15
 The design and funding of mortgages poses
  several policy issues
 In the short-term, problems in the wholesale
  funding markets for lenders are creating strains
 There is a longer standing set of issues about the
  types of mortgage lending in the UK
 The advantages of index-linked mortgages could
  be substantial

           David Miles, David.Miles@morganstanley.com
           Laurence Mutkin, Laurence.Mutkin@morganstanley.com   16
Table 6.8 Bank Securitisation of Mortgage Loans
                               Total mortgage loans
                                       outstanding                Securitised   Securitised
2006                                            (£bn)                  (£bn)           (%)

HBOS                                            219.0                   72.7            33
Abbey                                           101.7                   29.1            29
Lloyds TSB                                       95.3                   14.9            16
Northern Rock                                    77.3                   47.2            61
RBS                                              69.7                   15.7            23
Barclays                                         61.7                   12.6            20
HSBC                                             37.4                    3.7            10
Alliance & Leicester                             38.0                    3.4             9
Bradford & Bingley                               31.1                    6.7            22
Total                                           731.2                  206.0            28
Source: Company data, Morgan Stanley Research
             David Miles, David.Miles@morganstanley.com
             Laurence Mutkin, Laurence.Mutkin@morganstanley.com                               17
Figure 6.16 : The repayment burden of standard and
indexed fixed rate mortgages – proportion of income taken
by repayments
                                             0.25
                                                                                                    Repayment mortgage
                                                                                                    Indexed mortgage
     (sample mean across 3750 simulations)
       Average repayment as % of income




                                             0.20



                                             0.15



                                             0.10



                                             0.05



                                             0.00
                                                    1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
                                                                                     Years


Source: Morgan Stanley Research
Notes: Both mortgages are for the same amount borrowed and are completely paid off after 30 years. The indexed
mortgage illustrated here has two parts: the la rger fraction (60%) is a standard repayment mortgage where payments
are constant in real (consumer price adjusted) terms. The second (smaller) element is an interest only mortgage
which also pays a fixed real rate on the outstanding balance; but the outsta nding capital balance owed on this part of
the mortgage is linked to house prices. That (house price linked) part of the outstanding balance begins to be repaid
after 10 years and is gradually paid off by 30 years. This is why the payment profile moves bac     k up slightly after 10
years.David Miles, David.Miles@morganstanley.com

       Laurence Mutkin, Laurence.Mutkin@morganstanley.com                                                                              18

				
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