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The UK parliament’s Public Accounts Committee has just released a report criticising the government for failing to track whether it is doing a good job in its borrowing strategy.
You can read mainFT’s write-up here. Unfortunately, the PAC report is weak sauce. It mostly slams the government for not being able to measure the arguably immeasurable while making some hand-wavey comments about the risks of rising foreign ownership of gilts.
This is a shame, because a thorough, analytical investigation into government borrowing strategies would be hugely valuable. Because, although the debt management offices of most major developed economies don’t differ much in overarching goals, the outcomes can vary quite a bit.
The UK is a good example of that, since there is at least one area where it is the undisputed heavyweight world champ: the weighted average maturity (WAM) of its government bond stack.
While the WAM of the US Treasury market is about six years, and the German Bund market roughly seven, UK gilts on average mature 14 years from now — comfortably ahead of runners-up Switzerland and Japan.
The chart is from a new Goldman Sachs report on the UK Debt Management Office’s strategy (published last week, before the PAC report). The Goldman note is focused on the UK, but is more broadly interesting for anyone curious about the details of how governments fund themselves — one of Alphaville’s favourite subjects.
Occasionally you’ll see someone (usually hedge fund trading types) pipe up about how government should have taken advantage of the low-rate era to flood the market with long maturity debt. For example, Stan Druckenmiller last year said that failing to do so was “the biggest blunder in the history of the Treasury”:
Janet Yellen, I guess because political myopia or whatever, was issuing 2-years at 15 basis points when she could have issued 10-years at 70 basis points or 30-years at 180 basis points. I literally think if you go back to Alexander Hamilton, it is the biggest blunder in the history of the Treasury. I have no idea why she has not been called out on this. She has no right to still be in that job.
This showed a pretty bizarre and fundamental misunderstanding of how and why the Treasury funds itself in the way it does. Debt management offices are not traders, and nor should they be.
To be sure, they want to minimise borrowing costs — but over time. If investors think that they will be constantly picked off by tactical issuance then they will over time demand a premium. Targeting certain maturities can also lead to awkward maturity walls and rollover risks. You therefore want a nice smooth maturity profile across the yield curve.
For example, this is why Paul Volcker (then at the Treasury) made “regular and predictable” the cornerstone of America’s bond issuance strategy when US deficits started to swell in the 1970s. Other sophisticated DMOs generally pursue a similar strategy.
Moreover, sovereign debt plays multiple roles in most major economies. It’s not just how governments finance deficits. Bills and bonds also play a huge role in the functioning of the overall financial system, as Amar Reganti (a former US DMO official) points out.
Perhaps the US could and should have lengthened its own WAM before 2022. One of the reasons why short-term issuance ballooned in 2020 despite falling yields was because selling cash-like debt is the easiest way to rapidly fund exploding budget deficits without causing indigestion. Then the debt ceiling fights depleted its cash balances, which for the same reason are replenished mostly by shorter-term issuance. To put it glibly, DMOs tend to issue short in haste, and lengthen maturities at leisure.
Of course, this doesn’t mean that DMOs never shift the borrowing mix, or that all DMOs pursue the exact same strategy. As mentioned earlier, although the goals and strategies tend not to differ much, the outcomes can.
For example, the UK’s uniquely long WAM means that it did lock in cheap rates for longer than all other major countries. On the flipside, the UK’s uniquely heavy issuance of inflation-linked debt has cost it grievously lately.
To see what the optimal issuance mix might be for the UK — based on factors like funding costs and volatility — Goldman’s economists George Cole and Simon Freycenet built a model based on work done over the years by the US Treasury Borrowing Advisory Committee, a permanent body of big banks, asset managers, hedge fund traders that advises the US government on its debt issuance.
This model indicated that Gilts maturing in between three and 10 years are the peachiest tenor of issuance, and the optimal WAM for the UK was just five years — radically lower than the UK’s current maturity mix.
Our results are consistent with the findings of the TBAC model and, although our model is calibrated to the UK economy, they are generally applicable to other DMOs as well. These results contrast somewhat with the DMO’s own findings, which suggest that issuance strategies skewed towards the long end have the best cost-risk trade-off. Their analysis, however, does not rely on a macro model that drives a yield curve, but is contingent on a downward-sloping yield curve. In contrast, our model allows for the dynamic evolution of the yield curve through time, which in turn allows for a forward-looking issuance strategy. Most importantly, our results are consistent with recent behaviour of the UK DMO, where WAM increased during the period of low and flat curves following the GFC, and then has been falling recently as rates increased and curves inverted.
Notably, this holds even without assuming a lower structural demand for long-maturity Gilts due to the ongoing deleveraging of LDI strategies, but does not incorporate any conclusions on the optimal mix of linker versus conventional issuance.
Of course, it’s not a surprise that if you take a US model it will find that the optimal issuance mix looks a bit American. And as Cole and Freycenet note, there are other considerations at play — such as how credit rating agencies think the UK’s extreme WAM is a major strength.
But the UK’s average issuance maturity is already falling. This suggests it could and should shrink further in the coming years. Anyway, you can read the full Goldman Sachs note here. It’s more lucid and practical than the House of Commons report.
