Britannia Radio

Gilt ‘Russian Roulette’ Deters Pimco From U.K. Debt (Update1) 

By Matthew Brown and Anna Rascouet

July 9 (Bloomberg) -- The biggest gilt investors say U.K. government securities provide little value even though the Bank of England probably will extend its bond-purchase program.

The U.K.’s growing budget deficit and the central bank’s reluctance to say when and by how much it will expand so-called quantitative easing are keeping Pacific Investment Management Co., which runs the world’s biggest bond fund, andBlackRock Inc. from increasing their holdings of the securities.

Guessing which gilts the central bank is going to buy is like “playing Russian roulette,” said Philip Laing, the Edinburgh-based director of government bonds at Standard Life Investments, which has about 118 billion pounds ($191 billion) under management. “While they’ll probably extend it, we are focused on the end of quantitative easing.”

Investors are losing confidence in Prime Minister Gordon Brown’s economy as the government embarks on the biggest fund- raising effort in Britain’s history. The Treasury plans to sell a record 220 billion pounds of gilts this fiscal year to fund bank rescues and stimulus programs designed to pull the economy out of its deepest slump since World War II.

Yields on 10-year gilts will likely rise to 3.97 percent in June 2010 from 3.61 percent yesterday, according to the median estimate of seven strategists and economists surveyed by Bloomberg. Foreign investors cut their gilt holdings since the start of quantitative easing, selling 10.9 billion pounds of the securities in April, the most since at least 1982, according to central bank data. They sold 960 million pounds in May.

Extending Purchases

The Bank of England bought 107 billion pounds of gilts and almost 3 billion pounds of corporate bonds and commercial paper as part of a 125 billion-pound asset-purchase plan to reduce borrowing costs and stave off deflation. The bank has permission from the Treasury to increase that to 150 billion pounds if required.

The central bank may say it intends to take up that option after its monthly interest-rate meeting today, according to Stephen Nickell, a former member of the Bank of England’s Monetary Policy Committee.

“They still have a little bit left of the 150 billion, and I expect them to use it,” he said in an interview on July 7. “It’s possible” the central bank will even ask to spend more than 150 billion pounds, he said.

All 54 economists in a Bloomberg survey said policy makers will keep their key rateat a record low of 0.5 percent.

Extended Recession

The U.K.’s recession extended into a fifth quarter during the three months ended June 30, according to the National Institute of Economic and Social Research. House prices fell in June, a sign Britain has yet to shake off the property slump asunemployment increases, a report by Halifax, a division of Lloyds Banking Group Plc, showed yesterday.

Brown’s Labour Party has the support of 25 percent of voters, compared with 38 percent for David Cameron’s Conservatives, according to a YouGov/Telegraph survey on June 25. The poll showed the Conservatives extended their lead from seven points in December. U.K. parliamentary rules require Brown to call a general election by June of 2010.

The yield on the benchmark 4.5 percent gilt due March 2019 plunged 58 basis points, or 0.58 percentage point, to 3.06 percent in the two days after Bank of England announced the quantitative easing plan on March 5. It then rose as high as 4.08 percent by June 11 as optimism that the global economy was starting to recover sapped demand for the safety of government securities.

‘Layer of Complexity’

The yield has since fallen to 3.60 percent, as stocks declined amid signs that the economic recovery is sputtering, while the pound has dropped 1.9 percent since trading at a high this year of $1.6743 on June 30.

Buying securities of nations involved in quantitative easing “adds another layer of complexity” to investment decisions that are already difficult given the competing forces of an unfavorable economic outlook and increased debt supply, said Andrew Balls, a managing director in London at Newport Beach, California-based Pimco. “We prefer German bunds over gilts and Treasuries.”

German government bonds returned 0.5 percent this year, compared with losses of 1.6 percent from gilts and 3.2 percent on U.S. Treasuries, according to Merrill Lynch & Co. indexes. The German 10-year note yielded 3.27 percent and the equivalent Treasury 3.35 percent.

Targeted Securities

Should the central bank expand purchases beyond 125 billion pounds, it’s likely to start outside the current range of maturities targeted, according to New York-based BlackRock, the world’s third-largest custodian of financial assets, and Kokusai Asset Management Co. in Tokyo. BlackRock and Kokusai are among the top 10 holders of gilts by value, according to data compiled by Bloomberg.

The Bank of England excluded the 5 percent gilt due 2014 and the 8 percent security maturing in 2021 from its so-called asset-purchase facility “until further notice,” the central bank said on June 25. Policy makers will take into account the size of gilt purchases by the bank relative to the amount in circulation when deciding whether to withdraw them from the program, it said.

“They are running up against owning too much of any one particular security,” saidScott Thiel, the London-based head of fixed-income at BlackRock, which overseas more than $2.7 trillion. “If they were to expand it, they would probably go in both directions, down to two years and up to 30. We favor long Treasuries and bunds versus long gilts.”

Kokusai’s Concern

The Bank of England will probably start buying longer- maturity gilts, although not immediately, said Masataka Horii, who overseas $47 billion as a manager of the Kokusai Global Sovereign Open fund in Tokyo.

He’s avoiding longer-dated gilts, “because we’re concerned about the budget deficit,” Horii said.

U.K. Chancellor of the Exchequer Alistair Darling said on April 22 the budget shortfall in the year through March 2010 will reach 12.4 percent of gross domestic product, the most among the Group of 20 nations.

Britain is borrowing record amounts after rescuing financial institutions including Northern Rock Plc and Royal Bank of Scotland Group Plc. The Treasury, in the budget submitted to Parliament in April, estimated the bailout may cost taxpayers 50 billion pounds. The International Monetary Fund’s estimate is about 132 billion pounds.

The British economy contracted 2.4 percent in the first quarter, the most since 1958, the Office for National Statistics in London said June 30. Gross domestic product will shrink 4.3 percent this year, the Organization for Economic Cooperation and Development said last month.

“The Bank of England will want to keep some ammunition for a worst-case scenario, so there’s certainly a high degree of probability that they will extend the quantitative easing program,” said Brian O’Reilly, head of research at UBS Wealth Management in London. “We could very well see the program extended to 200 billion pounds in total.”

To contact the reporters on this story: Matthew Brown in London atmbrown42@bloomberg.net; Anna Rascouet in London atarascouet@bloomberg.net

Last Updated: July 9, 2009 04:36 EDT