DMO head says cheaper to issue short gilts

LONDON (Reuters) - Britain continues to enjoy strong overseas demand for short-dated gilts and selling this type of debt is the cheapest way for Britain to fund its budget deficit, the head of the debt issuance agency said.

Speaking after the Debt Management Office announced a bigger-than-expected issuance remit for 2011/12 on Wednesday, chief executive Robert Stheeman said he did not think the market would have any trouble digesting the planned 169 billion pounds of supply.

The DMO had to increase its issuance for 2011/12 to finance higher-than-expected government borrowing announced by finance minister George Osborne in his 2011 budget.

The DMO increased the amount of short-dated gilts it plans to issue to 58 billion pounds in 2011/12, or 34.3 percent of the total, from 53.177 billion in the 2010/11 fiscal year.

It cut issuance in the medium, or 7-15 year part of the maturity curve.

"We happen to think that short-dated gilts are a particularly cost-effective form of financing in the current environment. Mediums, at the margin, are less cost-effective," Stheeman told Reuters in an interview.

The market for government bonds with a maturity of up to 7 years is deep and liquid, and Britain has been issuing heavily in the segment for the last three years.

Overseas investors, who hold almost 40 percent of all existing gilts, are particularly keen on short-dated gilts, as are banks, which are required to hold safe, liquid assets to meet regulatory requirements.

"We continue to see strong demand from overseas investors at the short end," Stheeman noted.

High demand has driven down yields in the segment to below 1 percent, with yields on 7-year gilts currently at 3 percent. This means the government can issue new bonds with a very low coupon and therefore at less cost to the taxpayer.

Investors were quietly relieved that the 169 billion pound remit was not larger given the slippage of as much as 10 billion pounds a year in the government's fiscal consolidation plans.

Analysts said the DMO's strategy made sense.

"They are (turning) to focus on the shorter end of the market and the index linked end of the market," said Charles Diebel head of market strategy at Lloyds Corporate Markets.

"That's actually kind of clever. The biggest holder of UK gilts now is overseas investors and they like the five-year sector."

INFLATION PROTECTION

Stheeman said long-dated index-linked gilts also offered good value, but said the DMO was unlikely to heed calls from some investors to issue short-dated inflation-proof bonds.

"We also believe that linkers and long linkers in particular offer attractive funding rates. Traditionally our linker issuance has been focussed on the long end, we see no reason for that focus to shift," he said.

"I wouldn't expect people to assume that there will be much in the way of short linker issuance, if at all."

He added that the DMO would consult on issuing gilts linked to consumer price inflation in the 2011/12 fiscal year. Linker bonds are currently uprated in line with the older Retail Price Index, but a change in government policy means more private sector pension liabilities may be linked to CPI in future.

(Reporting by Fiona Shaikh, editing by Mike Peacock)