United Kingdom: Recent Economic Developments

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

Abstract

This paper reviews economic developments in the United Kingdom during 1991–96. The paper examines two sets of possible reasons why the United Kingdom's savings and investment rates are lower than elsewhere. The first consists of factors leading to lower optimal rates of savings and investment: these include demographics, economic structure and technology, a liberalized financial environment, and so on. The second consists of distortions leading to lower-than-optimal savings and investment rates. The paper also presents new estimates for the potential growth rate, the output gap, and the natural rate of unemployment.

V. GILT MARKET REFORMS AND INDEXED GILTS63

“The objective of debt management policy is to minimize over time the long term cost of meeting the government’s financing needs, taking into account of risk, whilst ensuring that debt management policy is consistent with monetary policy. This objective is achieved by: adjusting the maturity and nature of government debt instruments; developing a liquid and efficient gilts market; and offering cost-effective savings instruments to the retail sector through National Saving.”64

A. Introduction

157. The gilt market reforms announced in 1995—the adoption of a preannounced auction calender, the liberalization of the market for gilt “sale and repurchase” (repo) agreements, the reform of the system of taxing gilts and bonds, and the introduction of gilt strips—have been characterized by the Bank of England (BoE) as the “most extensive programme of reform since Big Bang”.65 Although the cost savings arising from such reforms are likely to be small, difficult to measure and swamped by the more fundamental impact of the pursuit of sound financial policies on investor confidence, improvements in market structure can be worthwhile, each basis point in lower funding costs reduces debt service payments by about £25 million annually. The reforms so far adopted or announced by the United Kingdom authorities are oriented toward bringing gilt market practice in line with what has come to be considered international best practice: a regular schedule of preannounced auctions, issuance concentrated on benchmark bonds, a primary dealer system, an open repo market, a strips market, and an active futures market for government bonds.66 In addition, the United Kingdom authorities have taken the lead, among major sovereign issuers, in the promotion of indexed bonds, making the indexed gilt (IG) market the largest indexed bond market in the world. This paper reviews, in Section B, the gilt market reforms announced in 1995 and considers, in Section C, the characteristics of the United Kingdom’s market for indexed bonds—an instrument poised to become increasingly important elsewhere as a vehicle for government borrowing.67

B. Gilt Market Reforms

Gilt issuance and the Funding Rule

158. The composition of the government’s borrowing is determined in the context of an annual “optimal issuance strategy” (Box 1), taking into account: the structure of the existing stock of debt, investor demand, the government’s tolerance of real and nominal risk, the current slope of the yield curve, the impact of new issues on yields, and the desirability of enhancing the liquidity of benchmark bonds. The United Kingdom authorities are currently considering how best to optimize the maturity structure and characteristics—fixed versus floating, indexed versus conventional—of new issues. While a definitive “optimal debt stock” is unlikely to emerge, increased recourse to indexed gilts as a funding source is viewed by the authorities as a step toward optimization. At the very least, the existence of an indexed gilt market comprising about 15 percent of outstanding gilt stock represents an important source of flexibility in determining the appropriate structure of new issues.

159. Beginning with the 1994/95 budget, the “remit” within which the BoE performs its debt management functions was publicly announced to increase the predictability and transparency of debt issuance. Central to this system is a preannounced auction calender which gives market participants notice of the approximate timing and issuance levels for various maturities and types of gilts.68 Recourse to tap sales was more strictly limited to meeting temporary excess demand for a particular stock or responding to an exceptionally sharp general increase in bond prices. It is expected that, with the exception of index-linked gilts which will continue to be issued exclusively through taps69, annual tap sales will normally constitute no more than 10 percent of expected total issuance. The government is considering the possibility of shifting from bid-price auctions to uniform-price auctions, weighing the possible gains from reducing the “winner’s curse”—winning, but at too high a price—against the risks of disruption arising from change.

Optimizing Cost and Risk in a Debt Portfolio

The optimal issuance strategy adopted each year seeks to balance the cost and risk of the stock of outstanding gilts. Decisions on how best to minimize the expected cost of new issues involve a number of judgements. For example, an issuer’s view of the likely future path of interest rates may differ from that embedded in the term structure of interest rates, suggesting that not all issuance patterns would result in the same expected cost. In this case, the issuer would concentrate new issues on the maturity range that appears to provide best value, favoring for example short maturities to long if the issuer judged the yield premia on longer maturities to be excessive. Alternatively, the issuer might attempt to capture, using indexed bonds, the premium investors are willing to pay for real return certainty. In addition, issuers often seek to reduce the illiquidity premia demanded by investors by concentrating issues in a limited number of benchmark bonds and other measures aimed at improving the operation of the secondary market. Most funding strategies involve tradeoffs: for example, the relative illiquidity of indexed bonds could partially offset the savings arising from the reduction of the premia demanded by investors for accepting exposure to inflation uncertainty; similarly, heavy reliance on short-term financing as a means of reducing the inflation risk premium could eventually lead to an untenable refunding schedule.

The actual cost of the issuance strategy is known only ex post, raising the need to limit the issuer’s exposure to inflation and real rate shocks. Conventional bonds are exposed to both types of shocks as the issuer would face higher than anticipated funding costs if either the actual rate of inflation were lower than that priced into the bond at issuance or if real interest rates were to fall below those demanded at the time of issuance. As discussed in greater detail in Section C, indexed bonds, in contrast, are exposed only to changes in real rates. A further refinement to risk control would be to develop a portfolio of debt obligations whose variability mirrored that of such government assets as tax receipts. In this regard, the government might arguably be better placed to hedge the risks of inflation than the private sector, and consequently be able to realize a net gain from capturing the inflation risk premium and bearing the corresponding risk.

Gilt repo market liberalization

160. The reform of the gilt repo market (Box 2) introduced on January 2, 1996 removed the exclusive right of gilt-edged market makers (GEMMs) to borrow gilts and of Stock Exchange money brokers (SEMBs) to intermediate gilt borrowing and lending. This liberalization was preceded by extensive preparations to ensure that a robust legal, regulatory and operational infrastructure was in place.

Repos

Repos—the combined sale of a security with a forward commitment to repurchase the security at a specified date and price—are typically short-term, collateralized money market instruments traded over-the-counter (OTC) in large denominations on terms negotiated between sophisticated, institutional market participants. At maturity, the temporary buyer (or provider of funds) returns the security and receives the original purchase price paid for the security plus interest. The buyer/reseller of the security concerned is remunerated at a rate of interest that reflects prevailing money market rates, the collateral’s attenuation of credit risk, and, in the case of a repo involving a particular gilt (a “special” repo), the scarcity value of the underlying security. (Securities with scarcity value include those with particularly high short interest, or which are the cheapest to deliver to settle a futures contract.) During the repo’s life, the temporary owner of the security has a wide degree of latitude over its disposition, but no right to any earnings arising from the security itself. The market risk of the underlying security is borne by the seller; from the buyer’s perspective, changes in the value of the collateral affect only credit risk.

161. To facilitate the expansion of the repo market, the withholding tax on gilt interest payments was modified to ensure that all market participants, regardless of their tax status or domicile, could elect to receive gross dividend payments. To minimize the impact of this reform on the Exchequer, U.K.-taxable investors entering into repos must hold their gilts in special accounts in the central gilts office and be subject to quarterly accounting for tax on gilt interest.

162 By offering favorable financing rates, flexible terms and the security of collateral to all gilt market participants, the liberalization of the gilt repo market should enhance market liquidity in a number of ways.

163. First, since repos are a form of short-term lending collateralized by bonds, their widespread availability extends the range of money market instruments, promotes the integration of bond and money markets, and creates a more continuous yield curve.

164. Second, repos are used in the same way as securities lending facilities to cover short positions. Market participants may acquire securities on repo to avoid settlement failure when securities promised for delivery are not available in inventory, or to cover speculative short positions. By facilitating the adoption of short positions, repos expand arbitrage opportunities and thereby enhance market efficiency.

165. Third, repos reduce the carrying costs of bond portfolios and facilitate levered bond positions. By using repos, gilt investors can gain access to the sterling money market to fund or lever their bond portfolios. Securities dealers and other intermediaries tap the repo market to finance their bond inventories, using the inventory as collateral to raise short-term financing at attractive rates. Similarly, banks and building societies with large bond portfolios use the repo market to manage liquidity and reduce funding costs.

166. Fourth, some securities dealers develop repo brokerage arms to intermediate repo transactions as a source of fee income.

167. Fifth, repos are secured money market instruments with yields only somewhat lower than comparable unsecured instruments. Banks with excess reserves use overnight repos as an alternative to the interbank market.

168. Sixth, repos are used by some central banks to implement monetary policy, to make self-reversing adjustments to the money supply, or, in foreign markets, as a tool of reserve management. Once the gilt repo market has matured, the BoE plans to use repos to implement monetary policy, bringing its practice in line with that of the proposed European central bank. Thus, in addition to any cost saving that might accrue from enhanced liquidity, the opening up of the gilt repo market represents an important institutional development for the implementation of monetary policy.

169. Finally, repos provide a link between cash and derivatives markets and widen arbitrage opportunities. An active repo market can facilitate the pricing, replication and hedging of futures, options and swaps. Repos also provide a market determined pricing mechanism for securities lending activities.

170. Early indications suggest that the repo market is becoming increasingly liquid and used by a growing number and variety of market participants. About 100 market participants had completed the necessary legal documentation within two months of the market’s liberalization. GEMMs, discount houses, banks, securities firms and wholesale brokers are the main participants of the repo market, followed by building societies and some foreign central banks attracted to repos as a treasury management tool, and, to a lesser extent, domestic institutional investors traditionally active in securities lending. The BoE expects the gilt repo market to expand to include treasury management operations of the corporate sector. By end-February 1996, outstanding gilt repos stood at £36 billion and daily turnover in January and February 1996 averaged £12 billion.70 There is also some initial evidence that the liberalization of the gilt repo market has contributed to increased gilt turnover (average daily turnover rose to £8.1 billion in the first quarter of 1996, compared with £6.2 billion in 1995) and lower financing costs for holders of gilt portfolios.71 However, it is too early to hazard a guess at the eventual impact of an expanded gilt repo market on Exchequer funding costs.

171. The liberalization of the gilt repo market introduced new types of transactions and trading practice. The BoE appears to have addressed the potential regulatory and operational pitfalls in its code of best practice for the gilt repo market, the promotion of a standardized gilt repo agreement, the imposition of capital adequacy and reporting requirements on gilt repo transactions, and adjustments to the Central Gilts Office (CGO) settlement system.

172. In particular, the success of a repo hinges critically on containing credit risk, notably through the security afforded by the underlying collateral. This security can be undermined by the failure of the buyer/reseller to perfect an interest in the collateral and by large, unanticipated variations in the collateral’s value.72 Failure to perfect an interest in the collateral can arise by not adequately segregating the security from the seller’s other assets.

173. The BoE has taken pains to contain these risks by imposing capital adequacy standards for repos. In addition, it has developed in conjunction with market participants a master agreement and a code of conduct for gilt repo transactions whose provisions include: absolute transfer of title to securities on repo; daily marking to market; initial and variation margin; custodial arrangements to ensure adequate segregation; the right of termination and automatic termination in some circumstances; netting arrangements in the event of accelerated termination; and a settlement system. Finally, the netting and close-out provisions of the legal agreement underlying gilt repos have been structured to ensure that they would not be interrupted by insolvency proceedings.

174. Although the increased efficiency and liquidity ensuing from an active repo market is expected to reduce funding costs over a full market cycle, widespread access to short selling may increase volatility. This risk should not be exaggerated, however, as market participants, even prior to the liberalization of the gilt repo market, were able to establish short gilt positions through futures, options and swaps.

175. The liberalization of the repo market affects market structure by eroding one advantage of being a primary dealer. However, the BoE appears confident that the other privileges accorded primary dealers—direct dealing with the BoE, special access to market information and BoE financing—are adequate compensation for the commitment to make continuous and orderly markets in gilts.

176. Although increasing the depth and diversity of the sterling money market is one of the objectives of the proposed reform, the increased competitive pressure on other money market instruments and short-term borrowing facilities may have unforeseen consequences, including increased bank disintermediation. There has not yet been any indication of a reduction in unsecured interbank lending, however.

Gilt Strips

177. The third element of the authorities’ current set of gilt market reforms is the introduction, planned for early 1997, of a gilt stripping facility (Box 3). The authorities’ intention is that eventually all medium- and long-term conventional gilts will be strippable; the possibility of introducing strips for shorter maturities is to be kept under review. Gilt strips will be open to all investors, although individuals will need to go through an agent. Strips will have the same credit features as ordinary gilts, and be settled through the CGO system.

178. To prepare for its introduction, changes are being made in the CGO settlement system and in the taxation of gilts. To permit the development of strips, the total return on gilts is, in most cases, now taxed.73 This rationalization will also eliminate the tax advantages of low-coupon versus high-coupon gilts, although outstanding issues of low-coupon gilts and individual investors are exempted from the tax change.

179. The main issues raised by the introduction of a gilt stripping facility include the maintenance of adequate liquidity, and ensuring that the decomposition and reconstitution of gilts do not adversely affect the underlying gilt market or gilt derivatives markets. To promote liquidity, the authorities have identified five strippable gilts with medium- to long-term maturities which together have an outstanding market value of £40 billion. Liquidity is also being enhanced by permitting the fungibility of gilt coupon payments from different underlying bonds. To facilitate this, the gilts identified for stripping have common coupon dates (7 June and 7 December). As a further aid to liquidity, GEMMs will be expected to make a market in gilt strips. In addition, gilt strip repos will be permitted. Because of liquidity concerns, IGs will not be strippable initially, although that possibility remains open should the IG market develop sufficient liquidity. The relatively small outstanding amount of IGs at each maturity and the lack of common coupon dates (inhibiting fungibility) are the main impediments to developing strips in that market. Although strippable bonds will be acceptable for delivery in futures contracts, individual strips will not.

Bond Strips

Stripping a bond consists of decomposing its constituent coupon and principal payments into separate zero coupon bonds. For instance, a ten-year bond can be decomposed into 21 separate zero coupon bonds consisting of 20 semi-annual coupon payments and the principal repayment. A bond so decomposed can as easily be reconstituted.

Investors are attracted to strips for three main reasons. First, zero coupon bonds have longer durations than their coupon-paying counterparts of similar maturity, permitting investors to construct bond portfolios with greater sensitivity to interest rate movements than would be possible using only coupon bonds. Second, strips permit the matching of liabilities without reinvestment risk—the risk that coupon payments can be reinvested only at a lower rate than that prevailing at the time of initial investment. This feature would facilitate, for example, the creation of annuities or the immunization of pension liabilities. Individual investors use strips to save for a specific future obligation, while professional money managers use them to adjust the interest rate sensitivity of bond portfolios.

Indexed Gilts

180. IGs (Box 4) were initially made available to tax-exempt investors in March 1981 and to all investors in 1982. By adopting IGs, the authorities signaled their commitment to reducing inflation, and sought to benefit from lower funding costs on the expectation that actual inflation would be lower than then prevailing market expectations.

181. Prior to their introduction in the United Kingdom, major sovereign issuers had been (and many remain) reluctant to introduce indexed bonds (and indeed indexation of any kind) for fear of being seen to capitulate to inflation. In this view, too ready an accommodation of inflationary shocks exacerbates their impact on prices, reduces the range of responses open to the authorities, and, by easing the pain of inflation, undermines popular support for restraint.

182. Indexed bonds are exempt from these objections to indexation, and offer a number of advantages for issuer and investor alike. First, far from representing a capitulation, indexed bonds penalize inflationary policies with increased debt service payments. Maintaining the real value of the bond’s cash flow imposes higher nominal payments on the borrower, thus eliminating the presumed benefit of the inflation tax and contributing to the credibility of monetary policy. Indeed, when they were first introduced, IGs were characterized as “sleeping policemen” that would awake to defend the interests of bondholders against backsliding in the effort to contain inflation. Of course, too much can be made of the discipline imposed by indexed bonds; in their absence, markets can impose similar restraint by ratcheting up the inflation risk premium on conventional bonds, and in particular those of longer maturities. Conversely, as the credibility of policies oriented toward maintaining price stability becomes unimpeachably established, the distinction between conventional and indexed bonds diminishes.

Indexed Bonds

An indexed bond differs from its conventional counterpart by promising an investor a certain real, rather than nominal, cash flow. In the absence of default, £100 invested in a conventional bond with a semiannual coupon of 10 percent generates a certain nominal cash flow of £5 every six months until maturity, when the principal is returned to the investor and the final coupon payment made. In contrast, the coupon and principal payments of an indexed bond are scaled to changes in the general price level to maintain their real value. Consequently, an indexed bond’s real cash flow certainty is gained at the expense of nominal cash flow variability.

By promising a certain real cash flow, an indexed bond reverses the exposure of borrower and lender to unanticipated changes in the price level. In the case of a conventional bond, nominal cash flow certainty protects the lender from deflation and the borrower from inflation: when the price level rises faster than expected, the real value of the cash flow paid by the borrower to the lender is eroded; when the rate of inflation falls below the anticipated rate, the real value of the cash flow is increased.

183. Second, the availability of a security offering stable real returns fills a gap in financial markets, as none of the other major asset classes provides a reliable inflation hedge.74 Pension plans with long duration liabilities linked directly or indirectly to inflation would benefit from such instruments, as would individuals seeking to protect the purchasing power of their retirement savings. Ready access to an indexed asset can also promote innovation in the types of retirement benefits available, including the direct indexation of private pensions.

184. Third, indexed bonds expand the available sources of funds to issuers, and reduce the costs of borrowing.75 Moreover, by eliminating the risk of unanticipated inflation, indexed bonds should command a premium, and thereby reduce borrowing costs, if only by a little. When markets are (unjustifiably) skeptical of a government’s commitment to reducing inflation, the reduction in borrowing costs may be substantial as indexed bonds would permit the government to profit from inside information on its own commitment to containing inflation.76 The divergent payoff patterns of conventional and indexed bonds expand the opportunities for the issuer to reduce borrowing costs through market timing.

185. Fourth, indexed bonds provide a useful indicator for the conduct of monetary policy since the yield spread between indexed and conventional bonds essentially reflects the market’s inflation expectations. The BoE has taken advantage of a broad IG market to construct a term structure of inflation using real and nominal gilt yield curves.

Indexed gilt market characteristics

186. IGs are semiannual pay noncallable bullet bonds whose principal and coupon payments are scaled to the retail price index (RPI) with a lag of eight months. The eight month lag is necessary to compile and publish the RPI, and to ensure that the nominal accrual rate is known in between each semi-annual coupon payment.77

187. IGs account for about 15 percent of the market value of all gilts outstanding. As in the case of conventional stocks, the Government has attempted to build up the size of outstanding IGs to promote liquidity. However, there are no benchmark issues in the IG market. Compared with the market for conventional gilts, the IG market is relatively illiquid, turnover low and spreads wide, especially in the case of large trades. The market values of the largest individual outstanding IG issues are one third those of the largest conventional issues outstanding. Short maturity IGs, with a large retail following, tend to experience more turnover than longer-dated issues locked away in the buy-and-hold investment strategies of institutional investors.78 Pension funds and insurance companies, holding about 80 percent of the outstanding stock of IGs, dominate the market. International investor interest in the IG market has not been strong.

188. The illiquidity of the IG market stems from a number of sources. First, as already suggested, the characteristics of IGs lend themselves to buy-and-hold strategies, thereby reducing the float. Second, illiquidity may beget illiquidity as investor appetite for IGs—suppressed (perhaps artificially) by low liquidity—makes the United Kingdom authorities cautious about increasing the volume of new issues. Third, the current real yield on IGs compares unfavorably with the real yield prevailing on conventional gilts using the authorities’ inflation target of 2½ percent as a deflator. Fourth, there are certain features of the primary and secondary markets for IGs that militate against liquidity: IGs are issued through taps only, GEMMs are not obligated to make markets in IGs, and there is no IG futures contract available for speculating in, or hedging or arbitraging IG exposure. Finally, international investor interest in IGs is low, reflecting limited familiarity with the instrument and concerns over low liquidity. Only a small number of other major sovereign issuers—including Australia, Canada, New Zealand, and Sweden—have indexed bonds, and the liquidity of these bonds is considerably lower than the IG market. As a result, switching trades across the indexed bonds of different issuers are rare. The recent announcement by the United States Treasury of its intention to initiate indexed bond issuance in early 1997 could boost international investor interest and contribute to IG liquidity.

189. Since their inception, IGs have traded in a real yield range of 2½–4½ percent(Chart 1). The yield spread between 10-year conventional gilts and IGs of comparable maturity has ranged between 3⅓ percent and 8⅓ percent. A real yield of about 4 percent79 compares favorably with the very long-term (since 1919) average real return of United Kingdom equities and long-dated gilts of about 7¼ percent and 1½ percent respectively.80 However, IGs have underperformed during the period since 1982, and the current real yield on conventional gilts (using the authorities’ inflation target of 2½ percent as the deflator) exceeds that on indexed gilts.

CHART 1
CHART 1

UNITED KINGDOM: BOND YIELDS AND INFLATION EXPECTATIONS

(In percent)

Citation: IMF Staff Country Reports 1996, 130; 10.5089/9781451814064.002.A005

Source: ONS, Financial Statistics.1/ Difference in yields on 7.75% Treasury loan (2012-15) and 2.5% Treasury index-linked bonds (2016).

Prospects for the IG market

190. IGs have the potential of reducing real funding costs by insuring investors against the risk of unanticipated inflation and increasing the credibility of monetary policy by reducing the attractiveness of the inflation tax. The possible contribution of IGs in developing an optimal debt structure has led the United Kingdom authorities to consider how to improve the liquidity of the IG market.

191. In the primary market, the authorities are weighing the merits of issuing IGs through preannounced auctions rather than taps. The increased predictability of such a system would permit investors time to plan for new supply and remove the aspect of market timing inherent in tap issues geared to sell into market demand. In the secondary market, the authorities are assessing the merits of identifying IG specialists committed to making markets in IGs as a means of ensuring immediate execution at reasonable cost. To be successful, a sufficient number of market makers would need to be identified, however. The lack of an IG futures contract would make it difficult for eventual IG market makers to hedge their positions, acting as a possible deterrent to would-be market makers. But successful futures contracts require liquid cash markets in the underlying security. Another possible approach to increasing liquidity would be to concentrate IG issues on a smaller number of benchmark maturities than at present. The introduction of IG strips would facilitate such concentration as a combination of such strips would in principle permit the construction of IGs of any duration. In addition, IG strips could expand investor demand by satisfying a need for the precise matching of a future stream of real obligations without reinvestment risk.

REFERENCES

  • Bank of England, 1993, British Government Securities: The Market in Gilt-Edged Securities [May].

  • Bank of England, 1995-96, “The Gilts and the Gilt Market Review”.

  • Bank of England, 1995, “The Gilt Repo Market”, Bank of England Quarterly Bulletin, vol. 35, [November].

  • Bank of England, 1995, Overview Papers, Bank of England Conference: The U.K. Index-Linked Gilt-Edged Market: Future Developments (London: September).

    • Search Google Scholar
    • Export Citation
  • Bankers Trust Australia Limited, 1993, “Inflation-Indexed Securities: Analysing the U.K. Index-Linked Gilt Market - Comparisons for Australia”1, [July].

    • Search Google Scholar
    • Export Citation
  • Belchamber, Christopher, 1988, The U.K. Government Bond Market (London, England: Credit Suisse First Boston Limited).

  • Bodie, Zvi, Inflation, 1988, “Index-Linked Bonds, and Asset Allocation”, (National Bureau of Economic Research Working Paper No. 2793, December).

    • Search Google Scholar
    • Export Citation
  • Bodie, Zvi, Inflation, 1990, “Inflation, Index-Linked Bonds and Asset Allocation: The Gains to Investors from Index-Linked Bonds”, The Journal of Portfolio Management, [Winter], pp. 4853.

    • Search Google Scholar
    • Export Citation
  • Bootle, Roger, 1985, Indexed-Linked Gilts: A Practical Guide (Cambridge, England: Woodhead-Faulkner).

  • Breedon, F., 1995, “Bond Prices and Market Expectations of Inflation”, Bank of England Quarterly Bulletin, Vol. 35.

  • Bröker, Günther, 1993, Government Securities and Debt Management in the 1990s, (Paris: OECD)

  • CS First Boston, 1992, “The Australian Fixed Income Market: Index-Linked Securities”, [December].

  • Deacon, Mark and Andrew Deny, 1994a, “Deriving Estimates of Inflation Expectations from the Prices of U.K. Government Bonds”, Bank of England Working Paper No. 23.

    • Search Google Scholar
    • Export Citation
  • Deacon, Mark and Andrew Deny,, 1994b, “Estimating the Term Structure of Interest Rates”, Bank of England Working Paper No. 24.

  • Fischer, Stanley, 1986, Indexing, Inflation, and Economic Policy (Cambridge: The MIT Press).

  • Fischer, Stanley,, “The Demand for Index Bonds”, Chapter 9 of Indexing, Inflation and Economic Policy.

  • Fischer, Stanley,, “On the Nonexistence of Privately Issued Index Bonds in the U.S. Capital Market”, Chapter 10 of Indexing, Inflation and Economic Policy.

    • Search Google Scholar
    • Export Citation
  • Hetzel, Robert L., 1992, “Indexed Bonds as an Aid to Monetary Policy”, Federal Reserve Bank of Richmond Economic Review, [January/February], pp. 1323.

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 1994, International Capital Markets: Developments, Prospects, and Policy Issues, (Washington, D.C.: IMF).

  • Munnel, Alicia H. and Joseph B. Grolnie, 1986, “Should the U.S. Government Issue Index Bonds?”, New England Economic Review, [September/October], pp. 321.

    • Search Google Scholar
    • Export Citation
  • Plenderleith, Ian.,Gilt Repo-and Beyond”, Speech presented at the 1996 Open Gilt Repo Market Conference (June 1996).

  • H. M. Treasury, 1996, Debt Management Report 1996-97, (London: H. M. Treasury, March).

  • H. M. Treasury and Bank of England, 1995, Report of the Debt Management Review, (London: HM Treasury, July).

  • Woodward, G.T., 1987, “Should the Treasury Issue Indexed Bonds?”, Congressional Research Service Report, No. 88-4 E, [December].

  • Woodward, G.T., 1990, “The Real Thing: A Dynamic Profile of the Term Structure of Real Interest Rates and Inflation Expectations in the United Kingdom, 1982-89”, Journal of Business, vol. 63, no. 3, pp. 373398.

    • Search Google Scholar
    • Export Citation
63

Prepared by David J. Ordoobadi.

64

H.M. Treasury and Bank of England (July 1995).

65

A primary dealer system was introduced in 1986 featuring gilt edged market makers (GEMMs) obligated to make continuous and effective markets in the whole range of gilt stocks. In return, GEMMs were accorded the right to deal directly with the BoE, given access to inter-dealer broker facilities, and permitted to borrow stock to establish short positions. Issuing procedures were also changed. Auctions became the main method of issuance, but there was no regular auction calender. Nevertheless tap issues continued to represent a significant share of new issues as the BoE retained the option of opening additional “tranchettes” of previously issued stocks at short notice in response to market conditions.

66

See Bröker (1993) and IMF (1994) for a review of recent developments in the structure of government bond markets.

67

The United States Treasury has recently announced that a 10-year bond indexed to the CPI would be issued in early 1997.

68

Innovations under the 1996-97 remit include monthly auctions, the auctioning of two different stocks in the same week to facilitate risk spreading by GEMMs, and permitting GEMMs to bid non-competitively for limited amounts of stock as a means of reducing their risk of being unable to cover client orders.

69

Auctions for IGs will be considered once that market becomes sufficiently developed.

70

The growth of the repo market contributed to strong increases in broad money in January, although its impact on the monetary aggregates waned thereafter.

71

The funding cost of gilt portfolios declined from LIBOR to LIB ID, minus a margin. At the same time, securities lending fees have declined from 25 basis points to 10 basis points.

72

In order to reduce the impact of the variability of the collateral’s market price on credit risk, a security underlying a repo is typically valued at its market price (including accrued interest) less a margin or “haircut” determined as a function the credit quality of the counterparty and the issuer, the term of the repo and the variability of the price of the underlying security.

73

Previously, gilt interest income was taxed when paid, while capital gains and losses were untaxed and unrelieved.

74

Real estate and commodity futures have been used by institutional investors as an inflation hedge with mixed results. Real estate suffers from basis risk, even lower liquidity than IGs, cumbersome investment vehicles, and the absence of a discernible market clearing price. Commodity futures can be highly volatile and must be assembled into baskets to provide a reasonable chance of tracking inflation.

75

In times of high inflation (or high uncertainty), indexed bonds also may help to secure funds that would otherwise not be forthcoming. This feature may be of particular interest to economies with fledgling financial markets experiencing difficulties in mobilizing capital because of investor fears of inflation.

76

Breedon (1995) estimates that market inflation expectations, as expressed by the spread between conventional and indexed gilts, has exceeded actual inflation by 170 basis points. However, not all of the spread between conventional and indexed gilts represents inflation premia: differential tax treatment and liquidity also affects this spread. Moreover, inflation risk premia appear to be variable with changes in expected inflation.

77

If the rate of nominal accrual remained uncertain between coupon payments, trading in IGs would be limited to coupon payment dates. Cash flows are not protected from inflation during the period from the establishment of the inflation adjustment and payment. The impact of the lag on the actual inflation protection afforded an investor is inversely related to the bond’s maturity. Similarly, the higher the rate of inflation during the intervening period, the greater the reduction in inflation protection. An investor will benefit if inflation falls during the lag, but lose if it rises.

78

IG liquidity is also adversely affected by the inability of dealers to hedge their indexed bond positions, with the result that dealers have the incentive to transact mainly on an agency basis. Moreover, not all GEMMs are active in the IG market.

79

Strictly speaking, the real return on an indexed bond is assured only if held until maturity, as its value in the interim will be affected by changes in real interest rates.

80

Over a similarly long time horizon, United States equities and long-term bonds have generated average annual returns of about 6 percent and 1 percent, respectively.