The UK Debt Management Office's syndication of its £1.25 billion, 50-year index-linked bond last month is an understandable strategy. The DMO did not want a repeat of the unenthusiastic response to its conventional 50-year auction in May. But while the deal went smoothly, it left some questions about very long-dated linkers unanswered.
Firstly, there is the matter of pricing. Books opened with indicative price guidance at 14 basis points to 19bps below the 2035 index-linked gilt. The book grew to £1 billion in four hours and eventually exceeded £2 billion on day two, when price guidance was tightened to 17bps to 19bps below the 2035. It finally priced at 19bps below the 2035.
Options
The UK had several options when it first thought about how to price the longest dated sovereign index-linked bond in the world. "You can look at the real yield curve and extrapolate forward, look at the breakeven curve and interpolate that curve forward, or have the mathematicians look at convexity," says Dave Hooker of Insight Investment's UK fixed income team.
With a potential investor base varying from price-insensitive trackers to hedge funds that value convexity, it was hard to pick a right or wrong approach for the deal as a whole.
But some market participants were critical of attempts to price the new linker from the 2035 ILG, which still trades rich, while the 50-year conventional is still cheap. "Going from the 35 wide doesn't work, to be honest," says one SSA banker. Pricing from the conventional using the breakeven curve makes more sense.
"History is littered with sovereigns discovering new parts of the curve and those parts trading cheap for a while. You should look at where the 50-year conventional is marked and does occasionally trade," says Chris Thomas, head of GBP inflation trading at RBS Financial Markets. "The 50-year zero inflation swap is marked around 304. If you work back assuming the new bond is floored at Libor flat, it comes a few basis points rich to Libor, where sovereigns should."
Demand
Then there is the question of appetite. The 50-year linker priced to yield a paltry 1.112%. For many accounts, that makes it a non-starter. "For active managers, the low absolute level of real yields and downward slope of real yield curve limits demand," says Hooker.
That appears to apply to hedge funds. According to the DMO, the final book was divided into two-thirds real money investors and one-third GEMMs. Just over £500,000 went to members of the public. "Hedge funds were not involved in the allocation," according to a DMO spokesman.
The bond certainly holds a theoretical attraction for hedge funds. According to research from Deutsche Bank, the 50-year linker's convexity is twice that of the 50-year nominal. Hedge funds could therefore be expected to pay more than domestic investors. But as Libor-driven investors, they have traditionally looked at shorter maturities in sterling. As yet, the 50-year swap is not liquid enough for hedge funds to get involved in this deal en masse.
With Barclays Capital, Morgan Stanley, RBS and UBS as joint bookrunners, the DMO gave itself European and US as well as UK distribution capability. In the event, only 10% of the allocation went to continental Europe, with domestic investors taking 90%.