A flicker of optimism in the UK’s public finances and the return of long-absent debt investors are fueling hopes the government’s bumper bond sale plan can be digested by the market.
(Bloomberg) —
A flicker of optimism in the UK’s public finances and the return of long-absent debt investors are fueling hopes the government’s bumper bond sale plan can be digested by the market.
Yields on sovereign notes are so high that even wary foreign investors and multi-asset funds can’t ignore them. Better-than-expected public finances data — and a rosier economic outlook — are hinting the UK Treasury will unveil a smaller-than-previously expected issuance plan on March 15.
“The investors that the market lost during the quantitative-easing period are returning,” said Richard Gustard, JPMorgan Chase & Co.’s head of sterling and dollar linear rates trading. “As yields rise from almost nothing to pretty significant numbers you naturally see more multi-asset type funds and retail investors re-entering the market.”
A few months ago, that wasn’t a given.
With energy subsidiaries climbing into the billions of pounds, inflationary pressures running hot, and the Bank of England starting to sell off its bond holdings, the fear was the wall of record net supply would swamp investors.
A quarter of a trillion pounds of supply next fiscal year still will mean a 50% increase from this year when including sales and previous buying from the Bank of England, Citigroup Inc. said, even as it pared its projection by almost £50 billion ($60 billion).
Investors and traders agree the UK’s Debt Management Office will need to be nimble, catering to portions of the curve where there’s most demand.
Buyers Awaited
In the years of quantitative easing, when the BOE was scooping up debt to keep yields ultra low, the only investors interested in gilts were those that had bond-specific mandates or needed them to fulfil investment protocols, according to Gustard.
That’s changing amid wagers inflation is near a peak and central bank tightening is approaching an end. Flows into exchange traded funds focused on European bonds hit a record €5 billion in January, according to data compiled by Bloomberg Intelligence. BlackRock’s iShares Core UK Gilts ETF has attracted inflows every week this year bar one. Ten-year gilt yields have risen over 250 basis points since the end of 2021.
“Sceptics may have underestimated the amount of cash being allocated out of other asset classes and back into fixed income,” Lee Cumbes, head of debt capital markets for Europe, the Middle East and Africa at Barclays Plc. “Current market levels mean that the traditional attractions of bonds have returned strongly, such as coupon income and hedging qualities.”
The list of returning buyers includes banks’ treasury departments, attracted by gilts’ cheapness compared with swaps, JPMorgan’s Gustard said. LGIM strategist Christopher Jeffery says re-hedging and asset allocation shifts could see insurers and pension funds absorb up to £50 billion of gilts a year.
Shorter Maturities
The UK government’s surprise budget surplus should mean around a £16 billion reduction in the Treasury’s bond-sale plan, although the impact will also depend on the fiscal watchdog’s economic forecasts, Barclays strategist Moyeen Islam wrote in a note to clients.
Even if the plan is trimmed, the DMO will need to slant its program more toward medium and short maturities, which are favored by foreign investors because they are less exposed to interest-rate risk, according to Theo Chapsalis, rates strategist at Morgan Stanley. In a recent consultation with the debt agency, some investors also advised it to raise more funds from retail investors to limit the volume of bonds hitting the market.
Assuming the supply of longer-maturity bonds is less than anticipated, HSBC Holdings Plc strategist Daniela Russell recommends buying 30-year gilts on an asset-swap basis.
“We are not denying the supply outlook is challenging and so repeated pockets of cheapening may be required around individual supply events,” she wrote in a note to clients. “However, the adjustment of valuations in recent months should help enable it to be absorbed smoothly.”
RBC Capital Markets estimates that the government could raise as much as £15 billion from retail investors over the next fiscal year, although much more than that could prompt accusations that it was getting in the way of commercial offerings, strategists said.
Inflation Risks
To be sure, inflationary pressures remain and are the principal source of investor uncertainty toward the UK, according to Laureline Renaud-Chatelain, a fixed-income strategist at Pictet Wealth Management. Sterling five-year inflation swaps imply a headline inflation rate of roughly 3% in the UK, compared with 2.6% in the euro-area.
Nevertheless, an expected economic slowdown in the second half of the year will put a damper on price pressures, potentially allowing 10-year gilt yields to drop more than 30 basis points to 3.3% by year-end, according to estimates from Pictet.
“I wouldn’t be too worried about supply with foreign investors and UK households coming into the market,” said Renaud-Chatelain. “As long as there is investor confidence.”
Next Week
- Euro-area and German inflation figures for February should garner most attention given policymakers’ commitment to data-dependent rate hikes and peak rates pricing cycle highs
- There are also lots of European Central Bank speeches scheduled including Philip Lane and Isabel Schnabel
- UK economic data is mostly second-tier and backward looking, but a large slate of speakers including an appearance by BOE Governor Andrew Bailey, may offer investors clues on the outlook for monetary policy
- Bond sales from the EU, Germany, the Netherlands, France and Spain are set to total around €34 billion ($35.8 billion) according to Citigroup Inc. The UK sells £3.15b of gilts and inflation-linked notes, while the BOE sells long-maturity bonds
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