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The Green Budget
Funding issues and debt management
January 2006
Professor David Miles +44 20 7425 1820 [email protected]
Niki Anderson +44 20 7677 6951 [email protected]
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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:

Public sector net debt is likely to continue rising as a share of national income
over the next few years, but empirical evidence suggests that this is unlikely in
itself to trigger higher real interest rates.

Demand for long-dated assets by defined-benefit pension schemes is set to
continue, but does not guarantee long term real interest rates will stay low.

The Debt Management Office would benefit from locking in low real rates of
interest now. Higher issuance of long-dated debt, significantly in index linked
form, could also support cost effective wider pension provision.

The proportion of debt outstanding in index-linked gilts has been broadly constant
in recent years. But the DMO seems prepared to take a more flexible approach
going forward.

The Government may need to explore new ways to raise funds as debt reaches
the 40% of GDP limit.
Please refer to important disclosures at the end of this presentation
Public sector net borrowing
£ billion
2004-5
2005-6
2006-7
2007-8
2008-9
2009-10
2010-11
PBR
38.8
37
34
31
26
23
22
Base case 1
38.8
36.8
36.7
36.7
31.5
28.8
25.0
MS central
case
38.8
36.0
37.0
37.2
33.6
31.3
27.8
MS worse
case
38.8
35.8
36.4
38.5
37.0
34.7
30.6
(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
2004-5
2005-6
2006-7
2007-8
2008-9
2009-10
2010-11
PBR
34.7
36.5
37.4
37.9
38.2
38.2
38.2
Base case1
34.7
36.5
37.6
38.6
39.2
39.5
39.6
MS central
case
34.7
36.4
37.6
38.6
39.4
39.8
40.1
MS worse
case
34.7
36.4
37.6
38.6
39.7
40.3
40.8
(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
Outlook for gross gilt issuance
£ billion
2005-6
2006-7
2007-8
2008-9
2009-10
2010-11
DMO/PBR
illustrative gilt
sales
52
68
64
47
47
47
Base case1
52
71
70
53
53
50
Morgan Stanley
central case
51
71
70
55
56
53
Morgan Stanley
worse case
51
70
72
58
59
56
(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
How does gilt issuance affect yields?

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.

The interesting question is whether increased issuance is likely to
bring about a rise in yields.

Historical evidence suggests that this is unlikely.
Please refer to important disclosures at the end of this presentation
Gilt issuance and yields
Gross (Net)
Issuance (£bn)
15-Year
Nominal Yield
15-Year
Real Yield
2000/01
10 (-9)
4.66%
2.06%
2001/02
14 (-4)
4.86%
2.37%
2002/03
26 (9)
4.71%
2.21%
2003/04
50 (29)
4.70%
2.04%
2004/05
50 (35)
52 (38)
4.74%
1.85%
4.30%
1.53%
Year
2005/06
Source: Bank of England, Debt Management Office
Please refer to important disclosures at the end of this presentation
Change in debt to GDP ratios for G7 countries
Debt to GDP ratio (%)
30
Change in debt to GDP ratio 2000-05
20
10
0
Canada
-10
France
Germany
Italy
Japan
United
Kingdom
United
States
-20
-30
Source: OECD
Please refer to important disclosures at the end of this presentation
International real yields on inflation proof bonds
3.875% TIPS 2029
3.4% OATi 2029
4.125% IG 2030
Real yield (%)
4
3
2
1
Jan-01
Oct-01
Jul-02
Apr-03
Jan-04
Oct-04
Jul-05
Source: Bloomberg
Please refer to important disclosures at the end of this presentation
Long-term real interest rates on UK conventional debt
6.0
5.0
Average Long Term Real Interest Rates
Long Term Average (1700-2005)
%
4.0
3.0
2.0
1.0
0.0
1700- 1750- 1800- 1850- 1900- 1960- 1970- 1980- 1990- 2000- 2005
1749 1799 1849 1899 1939 1969 1979 1989 1999 2004
Source: Morgan Stanley Research
Please refer to important disclosures at the end of this presentation
Government debt and real interest rates
12
250
% of GDP
200
Government debt to GDP ratio
10
Real interest rates (right-hand-axis)
8
6
150
4
%
2
100
0
50
-2
0
1700
-4
1738
1776
1814
1852
1890
1928
1966
2004
Source: Morgan Stanley Research estimates, ONS, OECD, Global Financial Data
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:

Whether or not low interest rates are sustainable is important for debt
management.

If today’s low levels of real interest rates on government debt are here
to stay then it is not so clear that locking in borrowing costs by issuing
long dated bonds is necessarily the best strategy.

But if the real cost of issuing debt is likely to be significantly higher than
today in the next 10 years, then the cost of funding can be minimised by
issuing long dated bonds now.
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:

Global savings glut?

Not big enough to explain large fall in interest rates
Please refer to important disclosures at the end of this presentation
Global savings
27
25
23
21
19
17
15
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
04
Source: IMF World Economic Outlook database (September 2005)
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:

Global savings glut?


Not big enough to explain large fall in interest rates
Rise in risk aversion/lower GDP growth?

Cannot account for fall in context of asset pricing model
Please refer to important disclosures at the end of this presentation
The sustainability of low interest rates:

Global savings glut?


Rise in risk aversion/lower GDP growth?


Not big enough to explain large fall in interest rates
Cannot account for fall in context of asset pricing model
Pension fund rebalancing?


Most convincing explanation for current low levels
But future impact on yields could be muted
Please refer to important disclosures at the end of this presentation
Pension fund bond purchases versus gilt supply
3.0
Net bond buying as a proportion of gilt
supply
2.5
Gilt supply assumes Morgan Stanley
central case projections (Green Budget)
until debt to GDP reaches 40% and then
assumes debt is issued to keep debt at
40% GDP thereafter, with nominal GDP
assumed to grow 4.5% a year
2.0
1.5
1.0
0.5
0.0
2005
2010
2015
2020
2025
2030
2035
2040
2045
2050
2055
2060
Source: Morgan Stanley Research estimates
Please refer to important disclosures at the end of this presentation
Percentage of conventional gilt sales
Funding and funding strategy
100%
Short
Medium
Long
75%
50%
25%
0%
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
Source: Debt Management Office
Please refer to important disclosures at the end of this presentation
Percentage of overall debt portfolio
Funding and funding strategy
100%
Conventional
Index-Linked
75%
50%
25%
0%
2000
2001
2002
2003
2004
2005
Source: Debt Management Office
Please refer to important disclosures at the end of this presentation
Funding and funding strategy

Strong case for significant funding from long-dated, substantially indexlinked, debt. This case is strengthened if long-dated yields are
temporarily beneath sustainable levels.

It is not that one can be sure that we are in the midst of a bond market
bubble - there are some reasons to believe that sustainable real yields
may have moved down.

But the scale of the fall in real yields is so great that the risks have now
become asymmetric - the chances of real yields going higher from here
are greater than their going lower. Locking in at today’s low real yields
by issuing long dated indexed debt is therefore sensible.
Please refer to important disclosures at the end of this presentation
Buying back company pension liabilities

David Willetts recently proposed that companies might be given the
option of, effectively, selling to the government that part of their
obligations to pay pensions to past and current employees that reflected
the contracted out rebate. In principle the idea is simple, though in
practice there are difficulties.

There would be an economic gain if the cost to the public sector of
having the obligation to pay higher state second pensions in future were
smaller than the cost to companies of holding the same obligations.
That would be true if companies were less able to manage the risks of
holding those obligations – longevity risks and risks of assets
underperforming.
Please refer to important disclosures at the end of this presentation
Buying back company pension liabilities

The issue of whether the government should buy some of these
pension obligations from companies is similar to the question of
whether the government should issue longevity bonds.

But the government already has huge exposure to unanticipated rises in
life expectancy. So it is far from clear that taking on more longevity risk
is optimal.

Buying pension obligations from companies would, however, generate
substantial cash. If those obligations were not treated as on a par with
government debt, then the strategy would ease the constraint that the
40% net debt limit creates.
Please refer to important disclosures at the end of this presentation
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