Bond Vigilantes have an interesting post up wondering if the DMO will redeem the war loan. After a moments reflection I have to wonder, why wouldn’t they? It’s seems to be a clearly profitable trade.
Perhaps the easiest way to see that the trade is in the money is to just take a guess at what a par yield for a perpetual would be today. As I write this the 2060 gilts are trading at 120.77, that is a yield of about 3.15%. A perpetual should have a very similar yield since in any event most of the present value is in the first 50 years worth of cash flows. For the sake of argument then let’s suppose that a new perpetual would also yield 3.15%. This implies that the DMO could buy back the War Loan at 100 and fund it by issuing a new perpetual at par but only paying a 3.15% running coupon. This would lock in a profit of 11p today, a very good deal for the UK taxpayer. (The number 11p means 11 pence per pound of face value of the bond, in what follows this is how I’ll express prices.)
Of course in reality the DMO would likely issue some more 2060s to fund the buyback and thus the present value is somewhat uncertain. However, I think we can make a pretty strong case that the trade is in the money. Our proprietary forward curve values the coupons from now until 2060 at about 87p and the 1 year rate 48 years forward is 3.14% (that’s the longest forward we can calculate from currently traded bonds). If we extrapolate the forward curve out into the indefinite future at 3.14% then the present value of the coupons beyond 2060 is about 22p for a total value of the perpetual payment stream of about 109p. Thus, calculating it this way means that buying War Loan back at 100p gives the DMO a profit of 9p upfront.
Of course, we can’t yet conclude that this is a no-brainer because the DMO does face some refinancing risk since it is unknown what rate ultra long bonds will yield when they come to refinance. However, we can check to see if this a reasonable worry by checking the breakeven yield, that is we can ask how high the refinancing interest rate would have to be before the DMO is just breaking even in present value terms. For example, if in 2060 the yield on a newly issued 50 year gilt is 5% then the DMO suffers a loss of 6.3p in present value terms on the post 2060 part of War Loan leaving them with only a 2.7p profit. At what refinancing rate does the DMO just break even? Well, a little playing with my calculator shows that this rate is greater than 5.5%, at a refinancing rate of 5.5% the DMO still makes a small profit of 0.6p.
So there we have it, whether or not it’s profitable for the DMO to buy back War Loan depends on your view of where long term yields will be in 2060. It’s pretty hard to have a firm view on that but we can ask what would constitute a reasonable view. Below is a graph of Bloomberg generic 30y Gilt yields going back to just before the Bank of England became independent (unfortunately there is no generic 50y yield). The key point is that the BoE’s independence caused this yield to immediately fall below 5% and it has remained below 5% pretty much ever since. Furthermore, most of this period was a time of significantly higher growth than we’re likely to get in the future. In short, it appears long yields over 5% are very unlikely, even in our long term future.
We thus conclude that it makes good economic sense for the DMO to call War Loan, to not call it is to leave a profit opportunity unexploited and to do that is to essentially throw away taxpayer money. One might even go so far as to say the DMO is obligated to call War Loan without delay.
Senior Quantitative Portfolio Manager, Co-Fund Manager
Nov 10, 2011 at 11:42am