UK DMO : Super-long and Perpetual Gilts Consultation

7 June 2012

The United Kingdom Debt Management Office has launched a gilts consultation exploring the case for the issuance of gilts with longer maturities than those currently in issue and/or perpetual gilts. The DMO will focus on the depth and sustainability of investor interest and the impact of issuance on the structure and functioning of the gilt market.

For reference, the longest conventional gilt is the 4% Treasury of 2060 (47 yr maturity, appx 23yr duration) : though various small undated gilts (such as the famous War Loans) exist. The longest linker is the 3/8% Treasury of 2062 (49 yr maturity, appx 46yr duration). The DMO is considering the issuance of gilts with 50yr+ maturities.

It would perhaps seem self-evident that any extension of maturities would be useful to defined benefit pension schemes as it would help in the more exact matching of assets to liabilities; whilst many closed schemes have average liability maturity of 20-25yrs, final liabilities can easily extend to 70yrs or above. However, let us consider the interest rate sensitivity of these proposed new gilts: their duration. This sensitivity measures the change in value of the bond for a 1 basis point change in the underlying yield and therefore gives an idea of the hedging efficiency of the bond : one would need to buy fewer higher than lower duration bonds to hedge a given liability against moves in the yield curve.

As bond maturities extend much past 30yrs, the incremental rate of increase in duration sensitivity slows right down : this is because so much of the value of a gilt lies in the early to mid coupon stream. Consequently, super-long maturity bonds are not especially more interesting for hedging than the existing long maturities. The real value in these would be that the Government could lock in its funding for much longer periods of time and would, presumably, be willing to issue at better yields. The 2060 conventional currently (6 June) yields 3.02% (nominal) with the 2062 linker -0.04%(!) and we would expect that the Government would pay a yield premium of perhaps 10bp for the conventional and rather less for the linker.

Are these proposed super-long bonds a good idea for pension hedging? Well, in theory yes, but a much better idea would be for the Treasury to really turn on the tap in the issuance of current longer maturities. Additional supply in the 30-50yr maturity range would help moderate the worst effects of current market yields.

The consultation closes on 17 August 2012.

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