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The Green Budget
Funding issues and debt management
January 2005
Professor David Miles +44 20 7425 1820 [email protected]
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
case
34.8
34.4
39.6
42.9
41.1
39.7
38.1
34.8
34.4
49.2
65.0
73.6
80.7
88.5
MS Sharp rise
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
case
32.9
34.3
35.9
37.8
39.3
40.6
41.7
MS worse
case
32.9
34.3
36.7
40.4
44.3
48.4
54.5
(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
Net Cash
requirement1
40
36
31
28
25
28
Redemptions2
15
15
30
29
15
16
Financing
Requirement3
54
50
61
57
40
44
Illustrative Gross
Gilt Sales4
50
48
59
55
38
42
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
illustrative gilt
sales
50
48
59
55
38
42
Base case1
50
52
71
68
53
57
Morgan Stanley
central case
50
54
73
68
54
58
Morgan Stanley
worse case
50
64
95
101
95
109
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
120
1998-9 2000-1
2002-3
2004-5
2006-7
2008-9
Gross gilt issuance
£ billions
100
80
60
40
20
0
1990-1
1992-3
1994-5
1996-7
Past actual
Base case 1
Morgan Stanley weaker near-term
1998-9
2000-1
2002-3
2004-5
2006-7
2008-9
PBR/DMO
Morgan Stanley central case
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
600
Gross Issuance
EUR bn
Redemptions
Net Issuance
Billion euros
500
400
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
100
81
205
38
101
90
157
32
97
90
183
35
142
101
194
35
154
118
214
34
154
122
190
38
157
111
168
38
166
132
166
28
177
110
193
24
194
123
177
25
196
144
222
37
192
114
191
32
Redemptions
423
271
380
270
405
309
472
332
520
388
504
340
475
338
492
363
503
364
518
367
599
436
529
357
Net Issuance
152
110
97
140
133
165
137
128
139
151
164
172
Germany
France
Italy
Spain
Gross Issuance
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
years
11
10
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
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
Conventional
* 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
Yield (%)
7
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
Rate (%)
4.5%
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)
% rate
7
7
6
6
5
5
4
Jun-97
4
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
Yield (%)
5.5
5.0
4.5
breakeven swap rate
4.0
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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Global Stock Ratings Distribution
(as of December 31, 2004)
Coverage Universe
Stock Rating Category
Count
Overweight/Buy
Equal-weight/Hold
Underweight/Sell
Total
632
880
374
1,886
Investment Banking Clients (IBC)
% of
Total
34%
47%
20%
Count
249
310
99
658
% of
Total IBC
% of Rating
Category
38%
47%
15%
39%
35%
26%

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Disclaimers
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