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Investment edge: Oliver Stones

Private clients generally shun ultra long-dated gilts as they just do not get enough bang for their bucks and there is too much inherent risk. But we see potential for holding the new 50-year gilts in some bespoke portfolios.

The Green Budget recently published by the Institute for Fiscal Policy and Morgan Stanley, points to the likelihood that the Government will be issuing significantly more debt over the next five years than over the past five years.

It argues that there are significant advantages to the Government issuing long-dated bonds, with a high proportion in index-linked form. In fact, the Government’s bond issuing arm, the Debt Management Office, only closed the consultation period on its proposal to issue ultra-long maturity gilt instruments a few days ago and it is likely that an ann-ouncement will be made in the Budget.

This may provide some potentially interesting investment opportunities for private investors.

In the 2004 pre-Budget report, Chancellor Gordon Brown asked the DMO to consult market participants on the possible introduction of additional gilt instruments, specifically ultralong (circa 50-year) conventional, index-linked gilts and index-linked annuity-type gilts.

The first issuance of 50-year conventional gilts is expected to be in the region of 3bn-5bn in the autumn. The Government is currently borrowing at historically low levels of interest rates which is an advantage when it comes to making future interest payments. Additionally, the Government can spread these payments over a very long period without having to pay extra to the buyers of its debt for taking on the extra time exposure.

However, this is precisely the reason that private clients have generally shunned these ultra-long dated gilts. Investors just do not get enough bang for their buck in 30-year gilt yields and the inherent risks of the extra 20 years volatility over 10-year gilts just makes it too risky to consider buying them.

The DMO states that in order to determine the maturity and composition of debt issuance, the Government takes into account, in addition to its own appetite for risk, the shape of the yield curve, the exp-ected effects of issuance policy and investors’ demand for gilts. One consequence of this is that Government debt is deeply skewed towards longer maturity bonds relative to other major Governments.

The biggest group of investors in gilts is the domestic pension industry. According to the National Statistics data, UK pension funds and insurance companies hold around 64 per cent of all gilts and 95 per cent of ultra-long dated gilts.

A major reason for this sudden insatiable appetite for long-dated gilts is the so-called pension deficit. The UK’s traditional heavy allocation to equi-ties for pension fund investment proved catastrophic in consecutive down years for equities, resulting in an investment culture that has shifted away from equities into the “safer” but more modest returns of bonds.

There is still plenty of way to go, however, before we meet the levels of the European and American pension fund industries’ exposure to bonds. Indeed, an independent report rec-ently stated that if the UK pension fund industry followed the UK insurance sector to the same degree in its investing in bond investments, there would be 150bn extra cash made available to the bond markets over the next four years.

The issuance of 50-year annuity gilts, both conventional and index-linked, will be closely monitored by us at Morgan Stanley Quilter as we see distinct investment oppor-tunities for private client portfolios, especially Sipps in drawdown, that could benefit from the pre-payment of principle. Their tax treatment has yet to be fully clarified but we think this is a potentially exciting new Government instrument.

Although we do not ant-icipate recommending these 50-year gilts to all our clients, we do see the potential for holding them in some bespoke portfolios where appropriate to exp-and durations.

It should be noted that although the long-dated gilt yields are not particularly attractive in 2004, the ultra-long-dated gilt sector returned a healthy performance of 9.2 per cent the one-five-year gilt sector of 4.5 per cent.

Overall, the changes proposed are a result of a shifting investment culture, expedient Government fiscal policy (smelling a good opportunity) and open a door to new investment opportunities for clients.

Oliver Stones is a vice president of Morgan Stanley Quilter and sits on the quarterly DMO consultation meeting with market investors as a representative of Apcims


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