Gilts: linkers and sukuk and perpetuals and floaters

Canadian-style Index-Linked Gilts, with three-month lag

In Sep 2001 the DMO consulted “on whether to adopt a new design for new issues of index-linked gilts”. JDAW’s reply advised against; and in January 2002 the DMO concurred. Then in Dec 2004 the DMO consulted about ultra-long gilts (JDAW’s reply), announcing (not consulting) that:

The DMO is also taking the opportunity to introduce a new indexation structure into any new index-linked gilts issued from 2005-06. Specifically, any new index-linked gilt issued from 2005-06 will use a three as opposed to the current eight-month indexation lag to the RPI. This reflects the adoption of a three-month lag as current international best practice. … Note that the DMO does not intend to introduce a deflation floor. The introduction of any new three-month lag index-linked gilts from 2005-06 does not mean that current eight-month lag index-linked gilts cannot be re-opened.

It happens that, in January 2004 the LSE switched from numeric Sᴇᴅᴏʟs to alphanumeric Sᴇᴅᴏʟs. So, for all ILGs with an eight-month lag, characters 3–12 of the ISIN are numeric; for all ILGs with a three-month lag character 5 of the ISIN is ‘B’.

Old-style Index-Linked Gilts, with eight-month lag

The introduction of inflation-linked securities was announced in the Budget Speech on 10 March 1981. Further explanation was published in May 1981. This was to be the first large inflation-linked government debt market.

These old-style ILGs have payments with an eight-month lag: the nominal÷real factor is the RPI eight months before the month of payment divided by the RPI eight months before the month of first issue. The eight-month lag ensures that the £ value of a coupon is known before the start of that coupon period, which can then be used for the calculation of accrued interest. However, in January 1987 the RPI was re-based from 394.5 to 100, so some base indices are re-based with a “/3.945”. Prices are quoted nominal.

Nominal payments are rounded: initially to the nearest penny per £100; for ILGs issued after Feb 1982 (so starting with 88s) the number of decimal places was upped to 4; and for the 35s only to 6 decimal places. This is in the “D.P.” column.

For 8-month ILGs issued ≤1992, so for those up to 30s, a change “to the coverage or the basic calculation of the Index … which would be materially detrimental to stockholders” would give holders a right to put the gilt back to HMT at inflation-adjusted par. But for 35s, and similarly for the 3-monthers, the index could be replaced with another index that “continues the function of measuring changes in the level of UK retail prices”.

Sukuk

Wikipedia says that “Sukuk are "securities of equal denomination representing individual ownership interests in a portfolio of eligible existing or future assets."”. The UK’s process started in Nov 2007 with a consultation, Government sterling sukuk issuance, the June 2008 response saying:

The Government’s objectives for Islamic finance are to:

• entrench London as a leading centre for Islamic finance in the world; and

• to ensure that all British citizens can participate in the financial system regardless of faith.

There was then a long gap, with an occasional comment such as that in Jan 2011: ‘The Government had reviewed the case for the issuance of sovereign sukuk. The Government had decided not to issue sovereign sukuk because it was judged not to provide value for money for the Exchequer but it would keep the situation under review.” Finally, the first was issued in 2014, the second in 2021.

UK sukuk “use the commonly used Al-Ijara structure”, which is explained on IslamicMarkets.com.

The ‘Perpetuals’

Much funding used to be via callable gilt-edged securities with no final maturity date. Income, and more income, and no promise of ever seeing the principal. Some could be redeemed only by Parliament, which delegated this power to the DMO in the Finance Act 2015, s.124 (see announcement in §A.1 on p93 of the Autumn Statement 2014, and explanatory notes for the legislation). All the perpetuals were redeemed during 2015. The following table draws heavily on (and adds to) pp23–24 of the DMO Annual Review 2014–15.

Floating-Rate Gilts

In 1994, with a bond-market crash continuing, the BoE issued a floater, paying (a private fixing of) Libid minus 12½bp. Two years later a second was issued.

There was a daily market fixing of Lɪʙᴏʀ, but not of Libid. Why use a private fixing? Was the BoE already aware of the problems that would later become the Lɪʙᴏʀ scandal? Or was it beneath the Old Lady’s dignity to use the same fixing as everybody else? Or both?

One coupon payment was mis-calculated. Bank of England, 20 Oct 1994:

The Floating Rate gilt, first issued in March 1994 with a further tranche in June, pays interest at 1/8% below the London Interbank bid rate for three-month deposits. The rate is reset every three months. By mistake, the interest payment to be made on 9 September was set on the wrong date, on 10 June rather than on 9 June. The error came to light when the next payment was being set, in September. Had the rate been correctly set, it would have been 0.01562% higher and the recipients of the interest payment on 9 September would have received an extra 0.39 pence per £100 nominal of stock. These persons are being individually notified and extra amounts are being paid with interest. The Bank is also contacting holders of the stock at the time the incorrect rate was announced who subsequently sold stock and may have suffered loss. The Bank regrets this mistake.

Nominal size was £2½bn+£2bn = £4½bn; error was 0.39 pence per £100; so the under-payment totalled £175,500.

The used fixing of Libid was a private fixing, and done only when needed, so it is not clear how the BoE could have known the value of this private fixing on a date on which it was not done. Three-month GBP Libor dropped 1.563bp between the 9^th and 10^th: perhaps this was used, with a small error added to hide the mechanism (perhaps, cunningly, an error chosen such that it was removed by rounding). Moral: needless complexity is needless.

Variable-Rate Gilts

The Bank of England Quarterly Bulletin, December 1981, p474:

Three Treasury Variable Rate Stocks (TVRS) have been issued: in May 1977 (to mature in November 1981), July 1977 (maturing in June 1982); and January 1979 (March 1983). Each was for £400 million with interest payable half-yearly, at an annual rate ½% above the daily average of the rate of discount on 91-day Treasury bills over a previous six-month period.

Errors of punctuation and maturity date—the Bank was sloppier then! The correct maturity is confirmed by the BoE QB, June 1983, p178: “the authorities … were committed to buying (at prices of their own choosing) whatever amounts of Variable Rate Treasury Stock 1983 (whose maturity date was 24 May) were offered to them.”

Wormell (1985), pp107–108:

There appear to be six reasons for the failure of the experiment. … Fifth, the ½ per cent margin over the Treasury bill discount rate become worth less, as a proportion of the rate, as interest rates rose: ½ per cent over a 7 per cent rate is very different from ½ per cent over 14 per cent. Finally, the return was based on the discount rate on Treasury bills and not the yield. The difference absorbed the ½ per cent margin when the discount rate on bills reached 13·914 per cent.

Belchamber (March 1988), p73:

Interest was paid semi-annually at the average of the weekly three-month Treasury bill rate over the period from the preceding ex-dividend date to the ex-dividend date prior to the payment plus a margin of 50 basis points in yield.

There were three issues in the late 1970s of £400m each. They were redeemable in 1981, 1982, and 1983 with maturities at issue of four, five, and six years respectively. These issues were not ultimately successful. The coupon structure was fully mismatched. A three-month rate was used to determine a semi-annual payment of a weekly refixing basis. This complexity made analysis virtually impossible and acted as a deterent to investors. No such issues currently exist.

— Julian D. A. Wiseman
London, February 2016 (and later updates)
www.jdawiseman.com