On 26 May 2005 the government auctions off an issue of the longest-dated bonds in recent UK history – with a maturity date of 7 December 2055. At the time of writing, details of the size of the issue and its interest rate remained sketchy, but the market expected it to be somewhere around the £2.5 billion mark, yielding interest of around 4.4 per cent. This does not look like a terribly high return for lending your money to the government for half a century with no inflation protection, but it reflects a voracious demand in the institutional market for very long-dated stocks.

Life insurance companies – especially those with large annuity funds – and pension schemes are expected to make up the bulk of buyers for this and any future issues, using them to help fund their liabilities. Fifty-year bonds are trumpeted as being particularly helpful for final-salary pension schemes that need to match their liabilities for deferred members – although 50 years is a very long time, extending way beyond the life expectancy of the average person in such a position.

Demand is expected to be strong. When the French government auctioned off 6 billion in 50-year bonds this February at a coupon of 4 per cent – just three basis points (0.03 per cent) more than its existing 30-year stock – it received 19.5 billion worth of bids. One third of buyers were based in the UK.

Just rewards?

This May’s UK issue is actually expected to carry a coupon between five and twenty basis points lower than the 30-year alternative, but this is not expected to put off investors. Pension funds and annuity providers have liabilities to match and, to a large extent, don’t care about value for money when doing so. Index-tracking bond funds, meanwhile, will also be forced to buy the issue because it will appear in the FTSE indices upon which they are based.

A much more appetising issuance is promised later in the summer – an index-linked 50-year gilt. The real return over and above the retail price index (RPI) is not expected to be more than about 1.5 per cent – less interest than investors could make on cash if they were to change savings accounts assiduously to take advantage of the best deals – but its guaranteed inflation protection plus a little bit extra is bound to appeal to the pension market.

It is, of course, the combination of guaranteed demand and low interest rates that led the Treasury to embark on this ultra-long strategy. As Tony Osborne-Barker, a pension investment adviser at Deloitte, points out, the government only has two options when it comes to raising finance: taxation or borrowing. Gordon Brown’s golden rule and the EU Stability Pact notwithstanding, as long as the government believes it can borrow money for a very long time at a very low rate of interest it is likely to continue to do so.

Were the yield curve (see glossary) to exchange its current inverted profile, with gilts of the longest maturity offering the lowest relative yield, and become positive, the Treasury could be expected to take the opposite strategy and concentrate its bond issuance at the shorter-dated end. In any event, if the government thinks it’s a good idea to borrow money from you at the moment then whether or not it is an equally good idea for you to lend that money is a question worth asking.

The bond scene

What, then, is the relevance of all this to the investor in the street? In some ways the institutional feeding-frenzy surrounding long bonds could be quite good news. As long as demand for very long-dated bonds keeps pace with supply and continues to depress that end of the yield curve, it should mean that the shorter-dated end will continue to look attractive. This end, with maturities in the range of 10–15 years for conventional gilts, is much more orthodox in terms of the kind of investment usually favoured by the holders, for instance, of self-invested personal pensions (SIPPs) who are looking to fund income drawdown.

The retail market for gilts, whether bought directly via a stockbroker, bank or internet trading site or invested in indirectly via managed funds, is now comparatively small. The days of the War Loan (see boxed text) are long gone, as are those during which you could pick up a couple of gilts along with your stamps and road tax at the Post Office. Investors have, in recent years, increasingly turned to corporate bonds for the fixed-income component of their portfolios.

According to Colin Harte, fund manager of the Baring Global Bond Trust, the UK retail market for pure gilt funds stands at £2 billion, while that for global sovereign bonds is £1.3 billion. UK retail investment in corporate bond funds, meanwhile, stands at more than £30 billion. This was initially fuelled by the excess yields such funds were able to generate, although, he continues, “spreads are narrowing”.

This narrowing is a result, Harte says, of corporate bond funds having predominantly been managed on the basis of yield while gilt funds have been much more actively managed in terms of duration.

Yielding an impact

This said, retail investors will usually have some exposure to the very long end of the bond market, although the extent to which 50-year issues have any effect on returns will depend very much on their volume compared to the market as a whole. This year’s conventional and index-linked issues, for example, are described by Deloitte’s Osborne-Barker as “tiny in comparison to existing debt issuance”. If, however, the Treasury continues injecting supply into the long end of the market over coming years, and other countries such as Germany follow suit, we could see some effect on yields in the medium term.

Retail exposure will come via two main routes: pensions and tracker funds. Although not a large market, retail investment in index-tracking gilt funds does exist and these vehicles will be forced to buy any new asset in whatever proportion it occurs within the relevant index. The main source of exposure, though, will be through annuities and defined-benefit pension schemes; the jury remains out, however, on whether the asset class will have a significant stabilising effect here.

What there can be little argument about is that the issuance of 50-year bonds has focused minds on the fixed-income asset class once again – even if many investors do not like what they see. Osborne-Barker sums up their dilemma: “Most investors are uncertain where to put their money at the moment. Bond yields are low and could potentially fall lower. Equity markets are looking pretty fully valued and property is looking shaky. I think people will hold off making any decisions now until September – it’s a classic case of sell in May and go away.”