Article 2.1 UK to repay tranche of perpetual war loans

By Elaine Moore

Financial Times October 31, 2014

One of Britain's oldest and most unusual national debts is to be repaid, marking the end of an era for a government bond that can trace its lineage back to the 18th century.

As Europe marks the centenary of the Great War, the Treasury has announced it will redeem bonds issued in 1927 by then chancellor Winston Churchill to refinance money borrowed to fund it.

Around 11,200 investors hold the 4% Consolidated Loan, the vast majority of whom are individuals with less than £10,000. Now the government is seeking to take advantage of falling borrowing costs on global capital markets by refinancing the debt at a time when long-dated gilt yields are at a 60-year low.

The ‘4% Consols', as the bonds are known, are perpetual gilts which have no fixed redemption date, giving the government the right to repay them at any time.

On February 1 all investors will be repaid their principal, marking the first time in almost 70 years that the British government has repaid a perpetual bond.

‘This is a great example of pragmatic and attentive debt management on the part of the UK government. I hope that this move is the first of many to cut the interest bill and save taxpayers money,' said Toby Nangle, head of multi-asset allocation at Threadneedle Asset Management, who has argued that the UK could save £300m by exercising its right to call the larger £2bn perpetual ‘War Loan'. Threadneedle is the second-biggest holder of the bond.

The government said it was looking into the practicalities of repaying the loan, which has a 3.5% coupon and trades below face value.

‘Some investors had doubted whether the 3.5% coupon war loan would ever be bought back by the Treasury but this is now clearly on the table,' said Michael Riddell at M&G Investments, which also holds the bonds.

The UK has one of the world's oldest government debt markets and the consolidation of bonds over the years means that the debt redeemed has its origin in the South Sea Bubble crisis of 1720 and the Napoleonic and Crimean wars.

On Twitter, George Osborne, the chancellor, wrote: ‘We'll redeem £218m of 4% Consols, including debts incurred because of the South Sea Bubble. Another finan­cial crisis we're clearing up after.'

FT

Source: Moore, E. (2014) UK to repay tranche of perpetual war loans, Financial Times, 31 October.

Figure 2.6 When gilts will be redeemed

Source: DMO, Quarterly Review January-March 2014 www.dmo.gov.uk/documentview. aspx?docname=publications/quarterly/jan-mar14.pdf&page=Quarterly_Review

The average maturity for conventional gilts currently outstanding is about 15 years, and for index-linked is 21 years - see Figures 2.6 and 2.7.

When gilts are sold by the government with a nominal value of £100, only the 20 Gilt-edged Market Makers (GEMMs)^[5] can submit competitive bids at the auction. They may do this for themselves or for their clients. For conventional gilts, all those who bid above the minimum needed to sell the bonds pay the price they bid (a multiple price auction). For index-linked gilts the pricing at the conclusion of the auction is different: all bidders pay the same lowest accepted price rather than each paying the price at which they bid (a uniform price auction).^[6] In return for exclusive access to auctions GEMMs must commit

Figure 2.7 Gilts in issue 12 March 2014

Source: DMO, Quarterly Review January-March 2014

to making a secondary market for gilts by providing continuous prices at which they will buy or sell for the gilts in which they deal.

As well as GEMMs submitting competitive bids at the auction, they can take up the post-auction option facility (PAOF), which enables successful bidders to acquire up to an extra 10% of their allocation at the average accepted (strike) price at conventional auctions and at the single clearing (strike) price at index- linked auctions.

Following an auction GEMMs can trade in the secondary market directly with investors, making available advertised prices between 8am and 5pm every business day in all those gilts in which they are recognised as market maker. They quote two prices: the bid price is the price at which they will buy, the offer price is their selling price. The difference between the bid price and the offer price is known as the dealer's spread, i.e. their potential profit. They are also able to trade gilts anonymously with each other through interdealer brokers (IDBs), who act as intermediaries for GEMMs. IDBs are required to post deals done on their screens for all other GEMMs to see. Below is the list of GEMMs and interdealer brokers at the time of writing.

t STRIPS market participant

* Retail GEMM

Table 2.2 shows details for the gilts issued over a one-month period.

Table 2.2 Examples of the results of gilt auctions

Source: www.dmo.gov.uk

Primary market for retail investors

As well as being able to buy gilts in the secondary market through GEMMs, individuals may bid at auctions providing they have applied for and been accepted into the Approved Group of Investors.^[7] The DMOs auction calendar is published up to a year in advance (see www.dmo.gov.uk), but greater details of the gilts to be offered for sale are announced a week or so beforehand. Approved Group investors can then obtain a prospectus and application form.

Investors wishing to bid for more than £500,000 nominal in a competitive bid must submit their bids through a GEMM stating the price they wish to pay. If the bid is below the price required to sell the gilts available they will receive no bonds, or only a proportion of those bid for.

Syndication and mini-tenders

Some gilts are sold by syndication, a process whereby the DMO appoints a group of investment banks to manage the sale of the bonds on its behalf. Lead managers and co-lead managers (the chosen banks) market the issue to investors. They ‘build a book', that is, they converse with potential investors and gain indications of offers for the bonds. When the size of the book (serious offers) reaches the DMO's sale objectives, the book is closed and bonds are allocated to investors at the prices previously discussed. In the period follow­ing the financial crisis the DMO increased the use of syndications significantly because it had to sell a vast quantity of gilts and the banks were capable of actively finding buyers.

Mini-tenders also take place between the major auctions. They are smaller issues which supplement the main auction sales, and are designed to tap into emerging pockets of demand for particular gilts.

Supplementary issues

If a gilt already in issue is ‘supplemented' (more issued) it keeps the same ISIN number - see Table 2.3, where we can see the details of a 3¾% Treasury Gilt with a redemption date of 2021, issued originally on 18 March 2011 with an initial issuance of £2.75 billion and paying a coupon of £3.75 annually in two equal semi-annual payments made on fixed dates six months apart; with gilt GB00B4RMG977 these payments are on 7 March and 7 September each year.

Since it was first sold, the government raised more money with this gilt, ending up with a total issuance of nearly £28 billion. The purchase (market) price of a gilt varies, depending on the coupon offered, the general level of interest rates in the markets, dealers' perception of future interest rates, and present and expected inflation rates. For gilt GB00B4RMG977 the initial price was £100.80 and the subsequent prices varied between £98.91 and £114.49. At maturity it will be worth £100 and as a gilt approaches maturity its price will become ever nearer to its par value.

Table 2.3 Issuance details of Treasury gilt GB00B4RMG977

Source: www.dmo.gov.uk

From the clean price (the price of the gilt excluding any accrued interest since the last coupon was paid - see later in the chapter) and yield at issue we can gain an impression of how the prevailing rate of interest for securities with a similar risk and maturity changed over the period March 2011 to January 2012, falling 157 basis points. Indeed, interest rates usually change daily, even if usually by very small amounts.

Who buys gilts?

Table 2.4 shows that the main purchasers of gilts are outside of the UK. Also, in recent years, one buyer has gone from being quite small to being dominant: the Bank of England bought large amounts of gilts on the secondary market to lower interest rates and try to revive the post-crisis economy (see Chapter 16 for a discussion of this ‘quantitative easing').

Table 2.4 Distribution of UK gilt holders December 2013

* ‘Monetary Financial Institutions’ replaced the ‘Banks’ and ‘Building Societies’ categories in January 2011 and excludes Bank of England holdings.

Source: DMO, Quarterly Review January-March 2014 www.dmo.gov.uk/documentview.aspx7docname= publications/quarterly/jan-mar14.pdf&page=Quarterly_Review

Article 2.2 discusses the operations of the DMO, with particular reference to the necessity to sell gilts to overseas investors.