$50 Billion Says Bonds Don't Care About Brexit
(Bloomberg) -- There’s one part of the U.K. establishment that’s unruffled by Brexit.
The Debt Management Office received a whopping 37 billion pounds ($50.1 billion) of orders for Tuesday’s sale of long-dated bonds. The government wound up issuing 6 billion pounds of 1.625 percent securities maturing in 2071.
The feeding frenzy shows the massive demand from life insurance and pension funds, which need to match their assets against their long-term liabilities. Due to U.K. pension accounting rules this need to secure ultra-long bonds is so strong it even pushes the yield curve inverted beyond the 25-year point — something that’s only gotten worse since the June 2016 Brexit referendum.
The current long benchmark, the 3.5 percent gilt due in 2068, trades at 160 percent of face value. Its yield is just a half a basis point higher than what you can get by paying the face value on the new issue. So it makes a lot of sense to switch out of the old deal and into the new one, and investors are more than aware of this — the price of the 2068 has been dropping like a stone.
The Bank of England may be trying, somewhat in vain of late, to push short-term interest rates higher. This is having little to no impact on yields at longer maturities. So it makes sense for the DMO to extend its yield curve as far out as it can. The longer the better — after a certain point, its borrowing costs fall. It wouldn’t be surprising to see a 100-year bond come at some point.
But there’s more to it than that. The 53-year security is surely one of the biggest slugs of long duration to be sold in one go in the regular market. The high-quality bond will have both the lowest coupon and longest maturity in the ultra-long segment of the government’s yield curve, so a one basis-point shift in yield will move its price more than any other bond (excluding inflation-linked bonds). The added benefit is that it will display even more positive convexity — its price will rise more for a downward move in its yield than its price declines for an equal upward move in its yield.
If you want to take an interest rate view, this bond is a way to do it, as it will be more sensitive than any other security to changes in rates. This makes the feeding frenzy look like a massive bet that long yields are headed lower. That looks like it’s overstating it — these bonds will get locked away and whatever outsized price declines follow may never see the real light of day.
This illustrates the one constant in the world of Brexit. There is insatiable demand for the long end, and the DMO is happy to oblige. U.K. government debt has a weighted average maturity of 14 years, the longest of all major bond markets. This turned out to be a big help during the global financial crisis. Though Britain’s debt to gross domestic product ratio was — and is — worryingly high, that there was no pressing need to refinance kept investors from panicking. Britain should get the same benefit as it muddles through its divorce proceedings.
It’s chaos for Prime Minister Theresa May at Number 10 Downing Street. But at the Chancellor of the Exchequer’s office in Number 11, there is one massive source of calm.
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