UK faces big test with Gilt syndication

* Sale coming against volatile backdrop

* Some investors steering clear

* Captive buyers expected to ensure success

By Michael Turner

LONDON, Oct (HKSE: 3366-OL.HK - news) 21 (IFR) - Tensions will run high next week for the UK's first Gilt syndication since chaos in the currency market and concerns over a potential hard Brexit catapulted yields higher.

Syndicated Gilt sales tend to be smooth exercises, with a captive audience of investors pouring in billions of orders over a very short space of time.

However, the market is not usually buffeted with the type of headwinds the UK has faced since the country voted to leave the EU, with the pound plunging to an all-time low against a basket of currencies last week.

"We have to face a number of challenging issues in the present environment and I do not think our role is necessarily going to get any easier," Robert Stheeman, chief executive officer of the DMO, told IFR.

"But I am confident about the market's ability to adjust in the necessary fashion to take down our supply in an orderly manner."

The Debt Management Office is planning to tap its £9.602bn 2.5% July 2065 Gilt via Barclays (LSE: BARC.L - news) , Lloyds, Nomura and RBS (LSE: RBS.L - news) .

As well as wild currency movements and a rise in inflation, the recent volatility has taken its toll on investors with some left nursing big losses.

Ten-year yields rocketed from 0.71% on October 4 to a high of 1.22% on October 17 - a level not seen since the run-up to the June 23 referendum. Bonds were back at 1.05% Friday morning.

The July 2065 stock was bid at 1.54%, 19bp higher than at the start of the month.

KEEP CALM AND ISSUE ON

The rising costs and volatility will not put the DMO off, however.

"As far as we are concerned, at the moment we are sticking to our published calendar and expect to proceed with the scheduled 2065 issuance next week, market conditions permitting," Stheeman said.

He added: "We do not adhere to the syndication programme blindly and without regard to wider market conditions but there is a virtue in sticking to predetermined published schedules, especially in times like these, as it helps to instil market confidence."

The last syndication, a £2.75bn 2065 linker tap, saw demand of over £10bn, though that was in July when markets were calmer.

Since then, conditions have become less stable, and for some investors the reward the UK offers is not worth the risk.

"I'm currently taking a negative view on UK fixed income," said Mark Dowding, co-head of investment grade at BlueBay Asset Management.

"We're short and making money out of being short UK rates. What value is there in buying 50-year Gilts at 1%? As for linkers, you get a negative real yield of -2%. Who would buy bonds at such low rates?"

STOCKHOLM SYNDROME

Not all investors think that way, and some, especially domestics, have little choice but to buy.

UK pension funds are one of the captive markets for Gilts and the country has an ace up its sleeve too.

"We have the Bank of England," said Hetal Mehta, senior European economist at L&G (LSE: LGEN.L - news) . "It's not buying an explosive amount of Gilts yet, but it has the firepower to buy more."

Non-domestic buyers, though, are not as compelled.

"Considering the size of the current account deficit, the UK clearly relies on foreigners buying its Gilts," said Mehta. "If that stops it would have quite a meaningful impact."

Overseas investors held 26.9% of Gilts as at the end of Q2 2016, according to the most recent DMO data.

"As long as the market is functioning normally there should in theory always be someone to fill the gap if any one group, [such as] international investors, were to reduce their buying," he said. "But I have not seen any hard evidence so far of this happening at the moment."

Central banks and sovereign wealth funds wanting to maintain their reserves may need to buy UK debt to replace redemptions, for example.

The weak pound may also encourage some to add to their Gilt holdings, as it will be too expensive to buy debt in other currencies using sterling reserves.

There is no question the DMO will be keen to see demand match its previous outings, with books of £21.8bn for the original £4.75bn deal in October 2015 and demand again topping £21bn for the subsequent £4.75bn tap in April this year. (Reporting by Michael Turner; editing by Helene Durand, Julian Baker)