The tricky task facing global DMOs
There was an interesting piece in the FT this week about how a group of cross-party MPs in the UK have encouraged the Treasury to do more to ensure that government debt is issued at the lowest possible cost to taxpayers.
Sounds sensible, but sensible is often far from simple, especially as this will likely be a record year for gilt sales and a general election is looming on the horizon. The caution also neatly illustrates the challenges facing many debt management offices the world over in 2024.
The role of the DMO
Given where we are in the cycle, with inflation stubborn and rates relatively high worldwide, global debt management offices (DMOs) are wrestling with the optimal way to issue debt.
It’s a hot topic, with the piece in the main section of the FT followed by another in Alphaville which took a deeper dive into the topic. That piece mentioned how Goldman Sachs has just issued a report that discussed the optimal maturity of UK debt issuance, which was timely given the fact that it has also been the week of the spring Budget.
With the Chancellor announcing his spending plans for the year, it’s been interesting to consider the other side of the Budget discussions i.e. how will the Chancellor pay for his promises. In an election year, and with the incumbent party well behind in the polls, it’s going to be intriguing to see the level of bond sales that the Chancellor needs to deploy to pay for the deficits he generates. Hence, the UK DMO is set for a challenging year – but they’re not alone.
Uniquely UK
As Alphaville points out, all global DMOs have essentially the same objective, aiming to minimise the cost of borrowing so that as little tax revenue as possible is spent on interest expenses versus actual public services. But how they go about doing that can vary significantly from country to country depending on the makeup of the new debt they issue and their existing outstanding debt.
The UK is unique as it has, by far, the longest weighted average maturity of debt compared to its peers. Unfortunately, this didn’t insulate the UK from a high-interest burden during the recent inflationary spike because the UK also has c25% of its debt linked to inflation. This is the highest among large economies, the next in line being Italy, which has 12%.
I was curious to know why this is the case and found a good FT explainer, which described how this practice started in the 1970s during the last inflationary shock when the UK was unable to borrow from the markets because investors were terrified of inflation’s effect on their bond holdings. So, the UK resorted to issuing “linkers” to try to attract investors. The first linker was issued in 1981 and, since then, the proportion outstanding has swelled way beyond the amount initially intended.
The best of both
As you might expect, there is no shortage of analysis over whether the UK is achieving the best “value for money” by adopting the unique combination of strategies outlined above.
In an upward-sloping yield curve environment (i.e. situation “normal”), longer-dated debt is more expensive than shorter-dated. So in a “normal” rate environment, the “cheapest” way to finance would be to issue entirely in the short end and continually roll it over. But in times of market stress (e.g. 2008), you run the risk of being unable to refinance and, thus, run out of cash for regular operations.
Longer dated debt is more expensive, however, the volatility of interest expense is lower. Linkers provide a unique “compromise” by allowing the UK to issue longer dated debt that is potentially cheaper than fixed rate debt. If actual inflation comes in lower than market expectations, the UK “wins” by issuing linkers that end up costing less over the life of the bond. But, of course, during times of inflationary stress, the cost of interest rises, and that debt gets very expensive, very quickly.
A mixed outlook
Goldman Sachs suggests that when rates are low, governments should go as long as possible. And, when rates are higher, they should shorten duration. This is simplistic but sensible, and they suggest that the ideal WAM for the UK is 5y versus the 14y of the current debt pile.
This analysis raises an interesting comparison for those of you who read last week’s post on mortgages. There’s a difference to be noted between mortgages, where the dream would be to fix a rate and guarantee it for as long as possible, and government debt, where there is likely a shorter ideal maturity. The difference is that governments never pay down their debt stock, unlike a mortgage, which amortises and disappears in your lifetime (all things being equal!).
Governments are always refinancing, so it goes without saying how important an optimal WAM is for global DMOs, especially in 2024, a year of such political uncertainty for so many major economies. Whether voters (or, dare I say it, future prime ministers or presidents) care about such matters is debatable (the debt they issue won’t be paid back during their time in office, anyway!). But with public finances under such strain, the consequences of getting on the wrong side of such an important issue could be considerable.