the uk debt management office borrowing on behalf of government

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1 the uk debt maagemet office borrowig o behalf of govermet PREPARED BY THE NATIONAL AUDIT OFFICE JANUARY 2007

2 This briefig was prepared by Mark Alle, uder the directio of Mike Suffield. The Natioal Audit Office scrutiises public spedig o behalf of Parliamet. The Comptroller ad Auditor Geeral, Sir Joh Bour, is a Officer of the House of Commos. He is the head of the Natioal Audit Office, which employs some 850 staff. He, ad the Natioal Audit Office, are totally idepedet of Govermet. He certifies the accouts of all Govermet departmets ad a wide rage of other public sector bodies; ad he has statutory authority to report to Parliamet o the ecoomy, efficiecy ad effectiveess with which departmets ad other bodies have used their resources. Our work saves the taxpayer millios of pouds every year. At least 8 for every 1 spet ruig the Office. For further iformatio about the Natioal Audit Office please cotact: Natioal Audit Office Press Office Buckigham Palace Road Victoria Lodo SW1W 9SP Tel: equiries@ao.gsi.gov.uk Natioal Audit Office 2007

3 the uk debt maagemet office borrowig o behalf of govermet CONTENTS key poit summary 2 Part 1: the DMO's role withi the Govermet s log term debt maagemet strategy 4 Borrowig by the DMO 4 Istitutioal arragemets 5 The Govermet s log term debt maagemet strategy 6 The aual fiacig remit 6 Part 2: the DMO s cotributio to the achievemet of the primary debt maagemet objective 9 The primary debt maagemet objective 9 Operatioal resposibility for delivery of the fiacig remit 9 Treasury moitorig of the DMO s performace 9 The DMO s cotributio to the primary debt maagemet objective 10 Pursuig a ope, trasparet ad predictable issuace strategy 10 Maagig the maturity ad ature of the Govermet s borrowig 10 Sellig gilts that achieve a bechmark premium 12 Developig a liquid ad efficiet gilt market 12 Cosistecy with the aims of moetary policy 14 Part 3: the DMO's performace reportig 15 Published iformatio 15 Curret developmets 16 Lookig ahead 18 appedix 1 our approach to this review 19

4 key poit summary This briefig is iteded to assist the Treasury Sub-Committee. It describes the Debt Maagemet Office s (DMO s) debt maagemet activities ad reportig arragemets. This summary sets out our key poits. Details of our work are at Appedix 1. Part 1 - the DMO's role withi the Govermet s log term debt maagemet strategy the Treasury has overall resposibility for cetral govermet debt maagemet ad the DMO, Natioal Savigs ad Ivestmets ad the Bak of Eglad have specific roles as agreed with the Treasury; the DMO s activities are guided by the Govermet s debt maagemet strategy, which is based o the priciples of predictability ad trasparecy as the most effective, log term way of miimisig govermet borrowig costs. This strategy reflects the coclusios of the 1995 joit HM Treasury ad Bak of Eglad review of debt maagemet; 1 there is o recogised way of quatifyig whether this provides the best approach. But the majority of respodets to our surveys of overseas debt maagers, UK market participats ad ivestors viewed this strategy as valid ad it is also i accordace with the Iteratioal Moetary Fud/World Bak Guidelies for Public Debt Maagemet (ameded December 2003). 2 the DMO s borrowig activities are cosistet with the Govermet s expressed prefereces of maitaiig: a broadly eve split betwee short, medium ad log term borrowig; ad approximately 75 per cet of the outstadig debt portfolio i omial debt (covetioal gilts) ad 25 per cet i real debt (idex-liked gilts ad Treasury bills). Part 2 - the DMO s cotributio to the achievemet of the primary debt maagemet objective the Govermet s primary debt maagemet policy objective is: to miimise, over the log term, the costs of meetig the Govermet s fiacig eeds, takig ito accout risk, whilst esurig that debt maagemet policy is cosistet with the aims of moetary policy. the primary debt maagemet objective is similar to those used by most overseas debt maagers ad is cosistet with Iteratioal Moetary Fud/World Bak guidace. However, measurig performace agaist the primary objective is ot straightforward; the Treasury states that the primary debt maagemet objective is achieved by: pursuig a policy for the issuace of gilts that is ope, trasparet ad predictable; maagig the maturity ad ature of the Govermet s borrowig; sellig gilts that achieve a bechmark premium; ad developig a liquid ad efficiet gilt market. the DMO s activities are cosistet with the Treasury s criteria for achievig the primary debt maagemet objective. 1 Report of the Debt Maagemet Review, HM Treasury ad the Bak of Eglad, July Guidelies for Public Debt Maagemet Ameded, Prepared by the Staffs of the Iteratioal Moetary Fud ad the World Bak. Ameded o 9 December

5 The UK Debt maagemet office borrowig o behalf of govermet Part 3 - the DMO's performace reportig the DMO (ad the Treasury) publishes a lot of iformatio about debt maagemet activities icludig DMO specific objectives ad targets. However, the structure of the existig published performace iformatio does ot provide a clear isight ito the DMO s cotributio towards achievig the primary debt maagemet objective; the DMO is developig a Strategic Debt Aalysis (SDA) Model which has the potetial to provide further improvemets i accoutability i the future; the DMO is ehacig its performace reportig ad (with the Treasury) aims to take forward the followig issues raised by the NAO durig the preparatio of this briefig: the DMO s reportig of its cotributio to achievig the primary debt maagemet objective should ecompass key iitiatives ad developmets supportig achievemet of that objective - for example, the itroductio of e-biddig (see paragraph 3.8); the DMO should seek to miimise, withi legislative costraits, the umber of differet documets that eed to be examied whe cosiderig its performace (see paragraph 3.8); the DMO should publish i its Aual Review a comprehesive list of the sources i which iformatio o its performace is preseted ad where these ca be accessed (see paragraph 3.8); to facilitate improvemets i the DMO s presetatio of iformatio o its performace, the Treasury should publish a statemet settig out what it requires from the DMO i the coduct of its debt maagemet operatios, both i terms of delivery of the remit ad i terms of the DMO s cotributio to the achievemet of the debt maagemet objective (see paragraph 3.7); ad the DMO (i cosultatio with the Treasury) should revisit the factors idetified as cotributig to achievemet of the primary debt maagemet objective, for example, to assess whether there are other ways to measure the bechmark premium give the difficulty of measuremet usig the curret methodology (see paragraphs 2.7, 2.14 ad 2.15).

6 the uk debt maagemet office borrowig o behalf of govermet Part 1 The DMO's role withi the Govermet s log term debt maagemet strategy Borrowig by the DMO 1.1 The Debt Maagemet Office (DMO) was established o 1 April 1998 as a Executive Agecy of the Treasury. Sice the, oe of its mai roles has bee to borrow moey to fiace govermet expediture. 3 This is doe through the sale of gilts ad Treasury bills, which are explaied i Figure At the ed of September 2006, the omial value of outstadig gilts was billio. This comprised billio covetioal gilts ad billio idex-liked gilts. As published i the 2006 Pre Budget Report, the DMO plas gross gilt sales of 62.5 billio i This is the total amout that is expected to be raised through the sale of gilts billio of gross gilt sales will meet the cost of re-fiacig maturig gilts. 4 This leaves et gilt sales (the actual icrease or decrease i total borrowig via gilt issuace durig the fiacial year) of 32.6 billio. Figure 2 shows the Govermet s gross ad et gilt sales sice I the Govermet expects to pay iterest of 27.4 billio o its borrowigs. This represets 4.9 per cet of Total Maaged Expediture (the Govermet s mai measure of public expediture). 1 Key characteristics of gilts ad Treasury bills Gilts - a log term liability (betwee 1 ad 50 years) of the UK Govermet. Gilts are idetified by their coupo (the total aual iterest paid to the gilt holder) ad maturity date for example, 4 per cet Treasury Gilt The Govermet issues two mai types of gilt: 2 Gross ad Net Gilt Sales Issuace billio Covetioal gilts the Govermet s paymets are fixed at the time the gilt is first sold. Gilts have a face or omial value expressed i price terms i uits of 100. For example, a holdig of 100 (omial) of four per cet Treasury Gilt 2016 pays 4 a year util 2016 whe the omial value (i.e., 100) is repaid. Idex-liked gilts the Govermet s paymets are liked to the Retail Prices Idex i.e. coupo paymets ad repaymet at maturity of the pricipal amout borrowed vary with chages i the Retail Prices Idex. The term gilt refers to their relative security as a ivestmet i.e., they are gilt edged. The UK govermet has ever failed to make iterest or pricipal paymets o gilts as they fall due. I the private sector the equivalet form of borrowig is called a bod Gross Sales Net Sales Treasury bills short term liabilities (up to twelve moths) of the Govermet that to date have bee issued with maturities of oe, three ad six moths. Treasury bills are issued at a discout. For example, a ivestor may pay for a Treasury bill that will repay 100 whe it matures after six moths. Treasury bills are a type of variable debt i.e., the cost to the Govermet of raisig fuds through issuace of Treasury bills varies depedig o the discout level demaded by ivestors Source: UK Debt Maagemet Office Fiacial Year The DMO has a rage of resposibilities i additio to govermet borrowig. These are: govermet cash maagemet, stewardship of the Commissioers for the Reductio of the Natioal Debt ad the Public Works Loas Board fuctios, operatig the Debt Maagemet Accout Deposit Facility, maagig the Govermet s liabilities associated with the Guarateed Equity Bod issued by Natioal Savigs & Ivestmets ad maagig the gilt purchase ad sale service. These are outside the scope of this briefig. 4 Govermets frequetly roll-over their borrowig i.e. udertake ew borrowig to meet the cost of maturig debt.

7 The UK Debt maagemet office borrowig o behalf of govermet Istitutioal arragemets 1.4 The DMO operates as part of the overall istitutioal arragemets for govermet debt maagemet i the UK (Figure 3). These arragemets stem from 1997 whe the Chacellor of the Exchequer trasferred operatioal resposibility for settig official iterest rates from the Treasury to the Moetary Policy Committee of the Bak of Eglad. At the same time the Govermet aouced that the Bak s debt maagemet resposibilities were beig trasferred to the Treasury. Subsequetly the DMO was established as a executive agecy of the Treasury with resposibility to udertake the govermet s debt ad cash maagemet operatios. The key reasos for this istitutioal separatio betwee debt maagemet ad moetary policy were: separatio of resposibilities a separate debt maager helps to esure that debt maagemet decisios are ot iflueced by iside iformatio ot available to the market about future iterest rate decisios; ad coflictig priorities these could arise if a sigle body was resposible for moetary policy ad debt maagemet. The itetio of istitutioal separatio was to esure that the implemetatio of debt maagemet policy would be uiflueced by short-term cosideratios over moetary policy, which required the debt maager to be distaced from the body resposible for moetary policy. 1.5 The Treasury has overall resposibility for cetral govermet debt maagemet. It: determies the overall amout of borrowig; approves the compositio of the Govermet s borrowig; appoits debt maagemet agets to advise o ad implemet borrowig programmes ad sets the framework ad parameters withi which each aget operates; ad moitors the performace of its debt maagemet agets. 1.6 The Treasury uses three debt maagemet agets: 3 Istitutioal framework for debt maagemet i the UK The area iside the dotted lie idetifies the debt maagemet authorities Bak of Eglad (FX team) HM Treasury (Fiscal Teams) (Debt & Reserves Maagemet team) UK DMO Computershare FX Wholesale Source: UK Debt Maagemet Office Retail NS&I Debt size Debt compositio Executio DMO i additio to sellig gilts ad Treasury bills, the DMO advises the Treasury o debt maagemet issues ad performs market maagemet activities. 5 Gilt registratio ad admiistratio fuctios are outsourced to Computershare, a commercial service provider; Natioal Savigs ad Ivestmets (NS&I) - develops ad markets a portfolio of ivestmet products to the domestic retail market. NS&I s forecast et cotributio to govermet fiacig as published i the 2006 Pre Budget Report showed that it expects to cotribute some 5.2 billio durig ; ad Bak of Eglad advises o ad arrages the sale of govermet bods deomiated i foreig currecies to fiace the UK s foreig exchage (FX) reserves. The most recet bod sold was a $3 billio five-year US$ deomiated bod issued i Jue No sales are plaed for fiacial year Sales of ew gilts by the DMO represet primary market activity. Subsequet oward sales represet secodary market activity. The DMO s market maagemet activities seek to promote active ad healthy primary ad secodary markets i UK govermet debt.

8 the uk debt maagemet office borrowig o behalf of govermet 1.7 I 2002, as part of the Iteratioal Moetary Fud s Fiacial Sector Assessmet Programme, a missio team visited the UK ad cocluded that cetral govermet debt maagemet practices were fully cosistet with IMF/World Bak guidelies. 6 This idepedet review was followed i by a Treasury led strategic Ladscape review of the DMO ad its role. This cocluded that the overall istitutioal framework was soud ad i keepig with iteratioal best practice. The Govermet s log term debt maagemet strategy 1.8 The Govermet s log term approach to debt maagemet stems from the 1995 Report of the Debt Maagemet Review 7 which examied arragemets aroud policy settig ad debt sales ad maagemet of outstadig debt. It cocluded that the guidig priciples of Govermet borrowig would be predictability ad trasparecy o the grouds that: predictability ad trasparecy reduce ucertaity about the debt maager s future actios. Ucertaity, for example, about the timig ad amout of borrowig, creates upward pressure o the Govermet s borrowig costs. Kow as risk premium, this higher cost reflects ivestors atural reactio to ucertaity that causes them to demad a higher retur for holdig govermet debt; ad upredictability ad opportuism (for example, sellig gilts without prior otice based o the debt maager s predictios about future movemets i iterest rates) is ulikely to geerate beefits for the Exchequer over the log term. This is because of the existece of risk premia ad the likelihood of good ad bad borrowig decisios eutralisig each other over time. 1.9 There is o recogised way of quatifyig whether a strategy based o predictability ad trasparecy or upredictability ad opportuism is the most cost effective approach to debt maagemet. However, the argumets set out above were reflected i most of the resposes we received to our surveys of iteratioal debt maagers, primary dealers ad ivestors. The aual fiacig remit 1.10 The Treasury s Debt ad Reserves Maagemet Report 8 icludes the DMO s aual fiacig remit. The remit is set by Treasury Miisters ad specifies the key parameters for borrowig i the year ahead. The DMO is ultimately accoutable to the Chacellor of the Exchequer for meetig the terms of the remit Prior to settig the remit, a Treasury Miister (usually the Ecoomic Secretary to the Treasury) chairs aual meetigs with major gilt market participats to solicit their views o the gilt issuace plas that should be icluded i the forthcomig year s remit. These views are take ito accout i the formulatio of the remit. The DMO publishes summary miutes of the meetigs o its website Treasury officials work closely with the DMO o the formulatio of the remit ad the key stages of the process are as follows: the DMO formulates advice o the remit ad submits this to the Debt ad Reserves Maagemet team i the Treasury ahead of the Budget. The advice sets out the DMO s aalysis ad recommedatios for the forthcomig fiacial year s remit based o cosideratio of all factors DMO judges relevat. The advice will iclude recommedatios o the gilt issuace split betwee differet types ad maturities of gilt; Treasury officials cosider the DMO s advice ad discuss with the DMO as ecessary before makig recommedatios to Miisters. These iclude recommedatios for the overall quatum of gilt issuace ad the split betwee differet maturities ad types of gilt for the forthcomig year; ad 6 Fiacial Sector Assessmet Programme Techical Note: Public Debt Maagemet i the Uited Kigdom, May 2003: IMF/World Bak: 7 I 1995, the Treasury ad the Bak of Eglad published the Report of the Debt Maagemet Review. This is available at 8 The Debt ad Reserves Maagemet Report is published aually by the Treasury. Reports are available o the Treasury s website: 9 Miutes of the Aual Meetigs chaired by the Ecoomic Secretary to the Treasury i 2006 are available o the DMO s website at:

9 the uk debt maagemet office borrowig o behalf of govermet followig Miisterial approval, the remit is published i the Debt ad Reserves Maagemet Report alogside the Budget The remit provides clarity to the gilt market about the timig ad ature of gilt auctios durig the year. The Govermet s prefereces i respect of the split betwee omial ad real debt, ad the maturity profile of its borrowig are key factors that uderpi the actios set out i the remit: omial debt: the real value of paymets varies iversely with iflatio. Covetioal gilts are a form of omial debt because iterest ad maturity paymets are fixed at the time the gilt is first sold. Cosequetly, the real value of these paymets declies durig periods of higher tha expected iflatio ad vice versa; real debt: the real value of paymets remais costat with chages i iflatio. Idex-liked gilts are a form of real debt because iterest paymets ( coupos ) ad fial redemptio paymets vary i lie with chages i the Retail Prices Idex (RPI) so that their real value is maitaied; ad the maturity profile of govermet borrowig: with some small exceptios, all gilts have a maturity date, i.e., the date that the Govermet repays the pricipal amout borrowed to the ivestor. Gilts are issued across a rage of maturities ad the DMO uses three classificatios: short dated (oe to seve years), medium dated (seve to 15 years) ad log dated (over 15 years). Treasury bills are all short dated with maturities of oe, three or six moths. The make-up of maturities withi the Govermet s borrowig is called the maturity profile The provisio of iformatio to ivestors about the Govermet s prefereces i respect of omial debt, real debt ad maturity profile helps provide the market with loger term cofidece about the ature of future Govermet borrowig. This is cosistet with the uderlyig priciples of predictability ad trasparecy ad the expected beefits these brig The clearest statemet of the Govermet s borrowig prefereces for the compositio of its debt portfolio is provided i the DMO s Aual Review. 10 This stated that curret policy was to: draw o past observatios of the relative proportios of the debt portfolio i omial versus real exposures ad carry this forward as a guidelie..i practice we assume a preferece for maitaiig roughly a quarter of the overall debt portfolio i the form of real exposure (i.e. idexliked gilts ad Treasury bills) The DMO s Aual Review also explaied the startig poit for cosiderig gilt sales each year as:.we ted to adopt the approach used i the fiacial year as a startig poit to defie a eutral or default strategy. This meas that i cosiderig the plaed compositio of gilt sales each year the default startig poit would be to split fairly evely betwee the short, medium ad log maturity bads to give a broadly eve maturity profile each fiacial year with cosideratio give to whether there should be departures from this default issuace strategy i practice (e.g. a greater skew towards log-dated gilt issuace) For example, the DMO researches the market to idetify sigificat medium or log term demad factors ( preferred habitats ) which may offer potetial cost savigs to the Govermet. The Aual Review states: A preferred habitat is said to exist where a distict group of ivestors strogly prefers to hold bods withi a specific maturity rage, or a specific istrumet type, to hedge its liabilities or to comply with regulatory requiremets.. 10 Available o the DMO s website:

10 the uk debt maagemet office borrowig o behalf of govermet 1.18 I recet years, the preferred habitat pheomeo has resulted i a shift towards issuace of log maturity gilts. This reflects strog demad for these istrumets from ivestors. For example, i the DMO itroduced ultra-log gilts (both omial ad real) with iitial maturities of approximately 50 years. I the fial quarter of the fiacial year, demad for log dated gilts (partly due to demad from pesio fuds seekig to match assets with liabilities) helped to reduce yields (borrowig costs) o log-dated covetioal gilts to their lowest levels i aroud 50 years (below 3.5 per cet) ad the real yield o the 50-year idex-liked gilt fell to a itra-day low of 0.38 per cet (18 Jauary 2006) The Govermet s prefereces i respect of the split betwee omial ad real debt ad the maturity profile as expressed i the DMO s Aual Review for are reflected i Figure 4. This illustrates the move i recet years towards greater issuace of log maturity gilts ad risig volumes of idex-liked gilt sales. 4 DMO issuace profile Percetages Issuace split (per cet) Medium Short Log ILG Amouts DMO gilt issuace by type ad maturity b Medium Short Log ILG Source: UK Debt Maagemet Office NOTE ILG = Idex-liked gilt

11 Part 2 the uk debt maagemet office borrowig o behalf of govermet The DMO s cotributio to the achievemet of the primary debt maagemet objective The primary debt maagemet objective 2.1 The UK s primary debt maagemet objective is: to miimise, over the log term, the costs of meetig the Govermet s fiacig eeds, takig ito accout risk, whilst esurig that debt maagemet policy is cosistet with the aims of moetary policy. This objective is cosistet with Iteratioal Moetary Fud/World Bak guidelies for debt maagemet 11 ad is similar to those adopted by may other coutries. 2.2 Overall resposibility for achievig the debt maagemet objective lies with the Treasury as pricipal but, i order to meet the Govermet s borrowig eeds, the Treasury operates through its agets, the DMO, Natioal Savigs & Ivestmets (NS&I) ad, for foreig currecy deomiated debt issuace, the Bak of Eglad. I pursuit of its overall resposibility the Treasury formulates the Govermet s fiacig programme, i particular: (i) the plaed proportios of fiacig to be obtaied from gilt ad Treasury bill issuace by the DMO; (ii) the cotributio to fiacig to be achieved through retail savigs products issued by NS&I; ad (iii) ay foreig currecy debt issuace by the Bak of Eglad to fiace the official foreig exchage reserves. 2.3 As show i Part 1, the major part of the Govermet s aual fiacig eeds is met through gilt ad Treasury bill issuace by the DMO. The DMO s fiacig remit sets out the quatum of fiacig that the DMO is required by Treasury to achieve through the sale of gilts ad Treasury bills, together with the plaed split betwee idex-liked ad covetioal gilts. Operatioal resposibility for delivery of the fiacig remit 2.4 The DMO is a executive agecy of the Treasury ad is, therefore, legally ad costitutioally part of the Treasury. However, it operates at arms legth from Miisters, which is a arragemet desiged to allow the DMO to cocetrate o delivery of the remit withi broad guidelies set by Miisters (ad published i the Debt ad Reserves Maagemet Report) but without day-to-day iterferece i the Chief Executive s resposibilities for operatioal decisios ad the ruig of the Office. 2.5 The DMO has operatioal resposibility for delivery of the fiacig remit. The key ways i which the DMO achieves operatioal delivery of the remit are through: (i) executio of market operatios (primarily gilt ad Treasury bill sales); (ii) moitorig progress agaist delivery of the remit ad reportig to the Treasury o progress; ad (iii) moitorig market developmets ad advisig the Treasury i a timely maer of ay chages that could ecessitate a revisio to the remit, providig aalysis ad evidece as ecessary to support its assessmet. Treasury moitorig of the DMO s performace 2.6 Oce the remit is set, the Treasury s two key ogoig resposibilities are to esure that: the DMO meets the Govermet s et fiacig requiremet through successful delivery of the remit. Most fudametally, the Treasury moitors DMO s gilt ad Treasury bill sales programmes to esure that the DMO raises the quatum of fiacig specified i the remit. I particular, the Treasury scrutiises the result of each gilt auctio ad aalyses mothly ad quarterly (upublished) reports from the DMO that report progress agaist the remit; ad i deliverig the remit, the DMO cotributes to achievemet of the debt maagemet objective. The meas by which this is achieved are cosidered further below. 11 The mai objective of public debt maagemet is to esure that the govermet s fiacig eeds ad its paymet obligatios are met at the lowest possible cost over the medium to log ru, cosistet with a prudet degree of risk - Iteratioal Moetary Fud/World Bak Guidelies for Public Debt Maagemet: 9 December 2003.

12 the uk debt maagemet office borrowig o behalf of govermet The DMO s cotributio to the primary debt maagemet objective 2.7 At preset there is o sigle idicator that ca demostrate the DMO s cotributio to the primary debt maagemet objective. However, the Debt ad Reserves Maagemet Report states that the primary objective is achieved by: pursuig a issuace policy that is ope, trasparet ad predictable; maagig the maturity ad ature of the Govermet s borrowig; sellig gilts that achieve a bechmark premium; ad developig a liquid ad efficiet gilt market. Pursuig a ope, trasparet ad predictable issuace strategy Clarity aroud debt issuace plas 2.8 The fiacig remit circumscribes the DMO s behaviour to esure that, i deliverig the remit, the DMO will coduct its operatios i a predictable ad trasparet way. I particular, the remit icludes: (i) publicatio of a auctio caledar up to oe-year i advace; (ii) a commitmet to hold quarterly cosultatio meetigs with major gilt market participats to solicit views o the forthcomig quarter s gilt issuace; (iii) advace quarterly publicatio of the gilt auctio caledar; ad (iv) advace publicatio of the size of each auctio. The Treasury moitors the DMO s performace agaist these aspects of the remit While the GEMMs buy gilts for themselves, they also purchase o behalf of cliets ad trasact i the secodary market. The DMO also holds quarterly meetigs with represetatives of ed-ivestors i.e. the wider gilt market (o the same day as the meetig with the GEMMs). The DMO publishes the miutes of its quarterly meetigs with GEMMs ad ed-ivestors o its website o the morig after the meetigs As part of our review we surveyed GEMMs ad ed-ivestors for their views o a rage of aspects of the DMO s debt maagemet activities. Our survey raised issues to which the DMO respoded as show i Figure 5. Maagig the maturity ad ature of the Govermet s borrowig 2.12 I cosultatio with the Treasury, the DMO ca use market maagemet techiques 13 to ifluece the maturity profile ad compositio of Govermet debt. The aim is to cocetrate borrowig ito bechmark gilts. These are gilts with large amouts i issue that pay iterest i lie with prevailig rates for the relevat maturity. They are the bechmark that the fiacial markets use to help price other istrumets of similar maturity. Figure 6 illustrates how the DMO has used gilt sales ad market maagemet steadily to icrease bechmark gilts as a proportio of the Govermet s borrowig Bechmark gilts are geerally more liquid tha other gilts i.e. because of the large amouts i issue they are relatively easy to buy ad sell. This makes bechmark gilts more attractive to ivestors ad helps to miimise borrowig costs. Regular cotact with market participats 2.9 The DMO udertakes borrowig usig a primary dealer system. I practice this meas that ivestmet firms registered with the DMO (Gilt Edged Market Makers GEMMs 12 ) provide a ready market for the DMO s sales of gilts. The DMO hosts quarterly meetigs with the GEMMs to seek their views o market issues ad future gilt sales. 12 There are 17 ivestmet firms recogised as GEMMs coverig both covetioal ad idex-liked gilts. 13 Various techiques are available to the DMO icludig: buy-backs, reverse auctios, coversios ad switch auctios. 10

13 the uk debt maagemet office borrowig o behalf of govermet 5 GEMMs/ed-ivestors: feedback from NAO survey Issue arisig 1. Wider cosultatio base the DMO should build the level of cotact with the uderlyig ivestor base, such as pesio fuds themselves rather tha just their fud maagers. This may give a more complete view of the uderlyig market demad for gilts. 2. Availability for bi-lateral meetigs the DMO should esure that market participats are aware that it is available for bi-lateral meetigs where they ca give feedback. 3. Explaatios of decisios the DMO should assess the scope to explai to market participats more fully ad promptly the factors uderlyig decisios it makes with the Treasury, ad cosider the most appropriate mechaisms to provide such iformatio. 4. Cosultatio meetigs the DMO should review the format ad attedees mix of the quarterly cosultatio meetigs with ivestors so that ivestors are willig ad able to cotribute. DMO respose As part of the DMO s cosultatio o issuace of ultra-log gilts, the DMO egaged directly ot oly with fud maagers, but also trustees, ivestmet cosultats ad academics, to form a more complete view o medium-term demad for gilts. Goig forward, the DMO iteds to maitai such cotacts with a diversified set of stakeholders, icludig overseas ivestors, whose share i gilt holdigs has bee risig steadily. The DMO has a ope-door policy ad all requests for bi-lateral meetigs by stakeholders have bee accommodated. The DMO has bee actively ecouragig stakeholders to visit ad i some cases has iitiated cotact itself. Resources allowig, the DMO iteds to maitai ad expad its ope-door policy, while payig particular attetio to esurig that o stakeholder beefits from privileged iformatio i the cotext of bi-lateral cotacts with the DMO. From , the publicatio of the quarterly gilt issuace caledar has bee accompaied by a statemet by the DMO s Chief Executive explaiig the mai factors behid the decisios. The agedas for the DMO s quarterly cosultatio meetigs with major gilt market participats ow also iclude some explaatio of the choices faced by the DMO i the quarter ahead. Goig forward, the DMO will cosider whether other meas are warrated to explai more trasparetly the ratioale behid its decisios. The DMO ow issues a ope ivitatio to the meetigs to up to 20 ivestors, o a first-come-first-served basis i order to ecourage broader participatio by ivestors. As a result attedace at the cosultatio meetigs is ow more diversified. The DMO has also ecouraged ivestors who caot participate at the cosultatio meetigs (e.g. those located outside Lodo or overseas) to cotribute views by telephoe or . The DMO has also reiterated that meetigs are held uder the Chatham House Rule so as to ecourage more active participatio. Source: Natioal Audit Office survey of GEMMS/ed-ivestors 6 Bechmark gilts as a percetage of total gilts i issue Percetage Source: UK Debt Maagemet Office 11

14 the uk debt maagemet office borrowig o behalf of govermet Sellig gilts that achieve a bechmark premium 2.14 A estimate of the impact that creatig idividual bechmark gilts ca have o borrowig costs ca be made by measurig bechmark premium. This occurs where the greater secodary market liquidity of the bechmark gilt (i.e., how easily it ca be bought ad sold) results i lower borrowig costs whe compared with existig o-bechmark gilts of a similar maturity Sice the DMO has published iformatio o the differet premia achieved by idividual bechmark gilts. Outcomes vary ad, while it is still possible to demostrate the cotiued existece of a bechmark premium, it is becomig icreasigly difficult to measure bechmark premia as the growig volume of bechmark gilts (as Figure 6 illustrates) meas the umber of suitable o-bechmark comparators has ievitably declied. Developig a liquid ad efficiet gilt market 2.16 A liquid ivestmet is oe that ca be bought ad sold easily i.e. it has a ready market. May ivestors prefer to hold liquid ivestmets as they kow they ca chage their holdigs relatively easily. Cosequetly, ivestors will geerally pay more for a liquid tha a illiquid ivestmet. From the Govermet s perspective as a borrower, a liquid ad efficiet gilt market helps to miimise borrowig costs The build up of bechmark gilts is a key elemet i the DMO s approach to the developmet of a liquid ad efficiet gilt market. Also importat are the operatioal practices adopted by the DMO. The preferred method used by the DMO (ad may other sovereig debt maagers) for the sale of gilts is by auctio. There are detailed procedures i place i support of gilt auctios but essetially GEMMs bid for the gilts available Where ucertaity exists about the ability of a auctio to esure a successful sale, the DMO (i agreemet with the Treasury) ca adopt a alterative approach. I September 2005, the DMO used a sydicated offerig 14 to issue successfully a ew 50-year idex-liked gilt. It was judged that a sydicated offerig would help avoid: (i) poor value for moey beig achieved at auctio this could have arise if ucertaity about the appropriate price caused ivestors to place bids at very coservative levels; ad (ii) reputatioal damage from a usuccessful auctio, with possible egative cosequeces for future sales of the ew idex-liked gilt Figure 7 shows the steady icrease i the size of the gilt market sice the DMO s creatio. This is drive by the size of gilt issuace, which is a fuctio of the Govermet s public fiace forecasts; i particular, cetral Govermet s aual et cash requiremet The growth of the gilt market over the past four years has also cotributed to a sigificat icrease i gilt market turover ad, by implicatio, market liquidity. Figure 8 shows that average daily turover has icreased from 8.7 billio i to 13.6 billio i ad to 14.7 billio i the first half of Figure 9 o page 14 shows that as the size ad value of the gilt market has icreased, so has the level of gilts owed by overseas ivestors, though at a faster rate, which has resulted i overseas holdigs risig as a proportio of the outstadig gilt portfolio Our survey of ivestors idicated that the level of liquidity i the idex-liked gilt market is lower tha for covetioal gilts. The DMO stated that this reflected the ature of UK ivestors who teded to be buy ad hold ivestors, particularly i idex-liked gilts (log term ivestors that hold gilts util they mature). However, the DMO cosiders that this issue merits further research to idetify whether scope exists to icrease liquidity i idex-liked gilts for example, by targetig maturity gaps ad sellig ew gilts to fill them. 14 The sydicated offerig ivolved the appoitmet of four book-ruers (draw from the Gilt-Edged Market Makers (GEMMs)) ad was formed for the purpose of joitly maagig the iitial offerig of the ew gilt. The book-ruers acted as lead maagers of the sydicate ad built a book of orders for the gilt prior to the sale takig place. 12

15 the uk debt maagemet office borrowig o behalf of govermet 7 Nomial ad market values of the gilt portfolio billio Market Value Nomial Value 250 March 99 March 00 March 01 March 02 March 03 March 04 March 05 March 06 Source: UK Debt Maagemet Office 8 Daily turover ad turover ratio 1 Turover ( billio) Turover ratio Aggregate daily turover billio Turover ratio to ed- Sep Source: UK Debt Maagemet Office (usig data received from Gilt Edged Market Makers) NOTE 1 Aggregate daily turover = the average value of daily gilt trasactios durig the fiacial year. Turover ratio (a measure of tradig itesity) = aggregate daily turover/value of total gilt portfolio 13

16 the uk debt maagemet office borrowig o behalf of govermet 9 Overseas gilt holdigs billio Percetage Overseas holdigs (Percetage of total) Overseas holdigs ( billio) Q Q Q Q Q Q Q Q Q Q Q Source: Office for Natioal Statistics 2.22 The DMO has a target set by the Treasury to publish the results of gilt ad Treasury bill sales withi 40 ad 30 miutes respectively. The rapid release of results is sigificat because it reduces market ucertaity, i.e., ivestors kow quickly how much stock they receive. The DMO achieves its targets comfortably. For example, i average publicatio times were 19 miutes for the results of gilt auctios ad 10 miutes for the results of Treasury bill teders Our survey of overseas debt maagers idicated the publicatio times achieved by the DMO are loger tha those i most respodet coutries icludig: USA (two miutes), Irelad (two miutes), Germay (two to three miutes) ad Frace (less tha five miutes). These faster times are possible because these coutries use e-biddig (electroic biddig) systems, rather tha a telephoe based system as used by the DMO. The DMO iteds to itroduce a e-biddig system i the first quarter of Cosistecy with the aims of moetary policy 2.24 The primary debt maagemet objective cotais a commitmet to esure that debt maagemet policy is cosistet with the aims of moetary policy. The key way i which the Govermet esures debt maagemet policy is cosistet with moetary policy is through the separatio of resposibility for the implemetatio of moetary policy (which resides with the Bak of Eglad) from debt maagemet operatios (which are the resposibility of the DMO). This arragemet is desiged to esure that the DMO is ot party to iside iformatio about moetary policy decisios ad thereby esures that DMO s actios do ot represet a sigal to the market about the path of future iterest rates. If the Bak has ay cocers that the DMO s operatios are coflictig with moetary policy it must relay these cocers to the Treasury, which will the discuss them with the DMO. 14

17 Part 3 GOVERNMENT DEBT MANAGEMENT the uk debt - ASSESSING maagemet THE PERFORMANCE office borrowig OF THE UK o DEBT behalf MANAGEMENT of govermet OFFICE The DMO's performace reportig Published iformatio 3.1 Figure 10 summarises the wide rage of iformatio published by the DMO (ad the Treasury) about debt maagemet activities. Operatioal targets 3.2 The Treasury sets ad moitors the DMO s performace agaist a rage of detailed operatioal targets that are published by the DMO i its aual Busiess Pla ad o its website. Performace agaist these targets is quatified, but this does ot measure how the DMO cotributes to the govermet s overall debt maagemet objective. Performace agaist specific aspects of the DMO s behaviour (e.g. the speed with which auctio results are released by the DMO) ca be quatified far more easily tha attemptig to place a umber o the DMO s cotributio to the primary debt maagemet objective. 3.3 I the private sector, fud maagers ofte use targets to assess their performace relative to a operatioal bechmark. For example, a equity based ivestmet fud might look to ear three per cet above the aual movemet i the FTSE100 share idex. However, we accept the DMO s view that it would ot be appropriate to use such a operatioal bechmark as a way of measurig the performace of the debt maagemet authorities for the followig key reasos: operatioal bechmarks ca ecourage short term thikig ad opportuistic behaviour to meet curret targets, for example, by takig advatage of short term market coditios to make a quick gai. This would ru couter to the priciples of trasparecy ad predictability ad could icrease borrowig costs i the loger term; 10 Published iformatio about debt maagemet activities Iformatio source Agecy Framework Documet DMO Aual Busiess Pla DMO Aual Review Debt Maagemet Accout Report ad Accouts ad the DMO Aual Report ad Accouts Published guidace/iformatio Areas covered Provides details of the status ad aims of the DMO, together with reportig ad accoutability requiremets. Cotais details of the DMO s aims, objectives, resposibilities ad operatioal targets, a brief review of the previous year, ad key plaig themes for the three years ahead. Gives iformatio about the DMO s activity ad ecoomic ad market developmets durig the previous fiacial year. It icludes some quatitative idicators about aspects of debt maagemet. Provide fiacial iformatio about the DMO s operatios ad performace iformatio orgaised by objective ad operatioal target as expressed i the Busiess Pla. The DMO s website cotais a large amout of material o its debt maagemet activities. I additio to the documets idetified above, this icludes: gilt market iformatio press releases, auctio results, GEMM details, Aual Remit progress, gilt idices, retail access to gilt market, commo questios ad aswers, gilt prices, gilt prospectuses; publicatios quarterly reviews, market cosultatio documets ad resposes (for example, ultra-log gilt istrumets); techical ad research papers (for example, GEMM Guidebook, Gilt Strippig ad Recostitutio, Smoothig the way for Ultra-Log Bods ); ad iteratioal guidace for example, World Bak/IMF guidace o debt maagemet. Debt ad Reserves Maagemet Report Published aually by the Treasury alogside the Budget, it icludes the DMO s Fiacig Remit for the year ahead. It provides details of the size, structure ad key developmets i the gilt market ad iformatio o the Govermet s debt maagemet policy. Source: Natioal Audit Office aalysis 15

18 the uk debt maagemet office borrowig o behalf of govermet operatioal bechmarks might ecourage iappropriate risk takig. For example, a debt maager might miimise i-year costs by issuig very short term debt. However, this could expose the Govermet to a greater degree of refiacig ( roll-over ) risk tha it would wat; a debt maager is likely to have limited cotrol over performace agaist a operatioal bechmark as borrowig costs are iflueced by ecoomic ad market coditios; a suitable operatioal bechmark caot be readily idetified. I the UK, gilts are the bechmark used by others to measure relative borrowig costs; ad the primary debt maagemet objective requires borrowig costs to be miimised over the log term. I the cotext of assessig performace agaist a operatioal bechmark, there is o agreed period of time that represets the log term. Average gilt yields 3.4 From the Govermet s perspective a gilt s yield is a measure of cost. Essetially, higher gilt yields at issuace equate to higher borrowig costs for the Govermet. I its Aual Review, the DMO publishes a rage of quatitative performace idicators icludig a compariso betwee the actual average yield of gilt issuace ad a rage of couterfactual yields (the average predicted yields that would have bee achieved if a differet issuace patter had bee followed). This is a similar approach to that used by Govermet debt maagers i other coutries. 3.5 Drawig o published iformatio, it is apparet that there has bee a geeral dowward tred i average gilt issuace yields sice the creatio of the DMO i.e., the Govermet has geerally borrowed more cheaply sice This reflects the wider macroecoomic eviromet i which the DMO has bee operatig ad is illustrated i Figure 11. Curret developmets 3.6 I its Aual Review, the DMO reported progress o the developmet of a Strategic Debt Aalysis (SDA) model. Details about the model ad the potetial beefits to accoutability that it may provide are set out i the pael below. Strategic debt aalysis model The DMO is developig a Strategic Debt Aalysis (SDA) model that has the priciple objective of quatifyig the trade-off betwee the costs ad risks associated with differet borrowig strategies. The SDA model does this by evaluatig the cost of differet gilt issuace strategies i a simulatio framework that replicates the typical or stylised behaviour of the UK ecoomy over the busiess cycle. The aim of the model is to provide the Treasury with quatitative illustratios of the possible log-ru or average costs per period of differet debt issuace strategies ad their associated risks. The model does this by capturig how the: size ad compositio of the debt portfolio; state of the real ecoomy; term structure of iterest rates; iflatio; ad the govermet s fiacig requiremet iteract to determie the cost of servicig the govermet s debt i a give period of time. The illustrative outputs of the SDA model also have the potetial to provide a poit of referece for explaiig the assumptios about the yield curves that uderpi the Treasury s decisios o the compositio of debt issuace ad its approach to maagig the debt portfolio. Although the model captures the key risks (i.e., the volatility of debt servicig costs) iheret i debt maagemet it does ot (ad caot) capture all the risks faced by the debt maagemet authorities (e.g. the risk that the gilt market does ot remai liquid or that the customer base for gilts is ot sufficietly diversified). Outputs from the SDA model have the potetial to ehace the accoutability of the debt maagemet authorities for decisios o debt issuace strategies by providig a quatitative way of explaiig the cosequeces of some of the key assumptios that lie behid the issuace strategies the govermet pursues. Such a quatitative explaatio would complemet the qualitative aalysis that uderpis recommedatios o the remit. Source: UK Debt Maagemet Office 16

19 the uk debt maagemet office borrowig o behalf of govermet 11 Average gilt issuace yields ad amout issued billio Average yield of gilt issuace (percetage) Gilt issuace ( billio cash) Percetage Average gilt issuace yields tred-lie Percetage Average yield of gilt issuace (percetage) Source: UK Debt Maagemet Office 17

20 the uk debt maagemet office borrowig o behalf of govermet Lookig ahead 3.7 There is a large amout of iformatio about debt maagemet available, icludig details of performace agaist the DMO s objectives ad targets as set out i its Busiess Pla. The rage of publicatios i which DMO reports o its debt maagemet activities is partly a fuctio of statutory requiremets. However, bearig i mid these statutory costraits, the DMO s performace iformatio could be preseted i a way that facilitates a better uderstadig of its performace i deliverig the full rage of its debt maagemet fuctios. To this ed, the Treasury should publish a statemet settig out what it requires from the DMO i the coduct of its debt maagemet operatios, both i terms of delivery of the Remit ad i terms of the DMO s cotributio to the achievemet of the primary debt maagemet objective. 3.8 The Strategic Debt Aalysis model may provide further improvemets to accoutability. However, the DMO has recogised that there is scope to make better use of ad build o existig iformatio to provide a more comprehesive view of its performace. I cosiderig arragemets for reportig performace the DMO should explore fully the followig optios: the DMO s reportig of its cotributio to achievig the primary debt maagemet objective should ecompass key iitiatives ad developmets supportig achievemet of that objective (for example, the implemetatio of e-biddig); ratioalisatio of curret arragemets: the DMO s aims, objectives ad targets are set out i differet documets (Agecy Framework Documet, DMO Busiess Pla ad the Fiacig Remit) while performace iformatio is also published i a variety of documets (DMO Aual Review, Debt Maagemet Accout Report ad Accouts, DMO Agecy Accouts). The DMO should seek to miimise withi legislative costraits, the umber of differet documets that eed to be examied whe cosiderig its performace; ad publicatio of a comprehesive list of the sources i which iformatio o its performace is preseted, together with iformatio o where this iformatio ca be accessed. 18

21 Appedix 1 the uk debt maagemet office borrowig o behalf of govermet OUR APPROACH TO THIS review The mai elemets of our work were: a survey of overseas debt maagers; a survey of all Gilt Edged Market Makers ad Represetatives of Ed Ivestors; meetigs with DMO ad Treasury staff; work-shadowig withi the DMO; ad attedace at key evets. Survey of overseas debt maagers We set a questioaire to a rage of overseas debt maagers. The coutries were members of the OECD debt maagemet workig group ad active i the developmet ad ehacemet of global debt maagemet practice. The followig coutries respoded to our questioaire Caada, Demark, Frace, Germay, Republic of Irelad, Netherlads, New Zealad, Portugal, Swede, USA. The questioaire sought iformatio across a rage of issues: istitutioal framework ad resposibilities; debt maagemet objectives ad strategy settig; ad debt maagemet operatios. The questioaire served two mai purposes: to help develop our kowledge of the subject area ad the differet potetial approaches to debt maagemet; ad to highlight sigificat differeces of approach that merited iclusio i this briefig. Survey of all Gilt Edged Market Makers ad Represetatives of Ed Ivestors We set a questioaire to all 16 Gilt Edged Market Makers operatig i the market at that time ad 20 Represetatives of Ed Ivestors. We received resposes from 9 Gilt Edged Market Makers ad 9 Represetatives of Ed Ivestors. The questioaire sought views o the impact o borrowig costs of the log term debt maagemet strategy ad the effectiveess of cotact with the DMO. Meetigs with DMO ad Treasury staff We held meetigs with key staff at the DMO ad the Treasury durig the life of the project. The meetigs provided much of the source material for the briefig ad facilitated the developmet of issues ad the preparatio of a agreed fial documet. Work-shadowig withi the DMO NAO staff spet time at the DMO to gai a first-had isight ito operatioal activities. This icluded observig maagemet meetigs o future issuace ad attedig a gilt auctio ad Treasury bill teder. Attedace at key evets NAO staff atteded key debt maagemet related evets durig the life of the project: Treasury/DMO debt maagemet workshop; cosultatio meetigs with Gilt Edged Market Makers ad Represetatives of Ed Ivestors; ad meetig of the OECD debt maager workig party o public debt maagemet. 19