UK debt chief fears further fall in bond market liquidity

By David Milliken LONDON (Reuters) - Britain's government bond market risks becoming more volatile due to reduced liquidity and increased uncertainty over U.S. monetary policy, the head of the country's debt issuance agency said on Wednesday. Robert Stheeman, chief executive of the UK Debt Management Office, said banks were becoming less willing to trade gilts due to a mix of tougher regulation and changing business models, similar to other bond markets. Since the financial crisis, regulators have required banks to set aside more capital than before if they wish to trade bonds. Banks have also streamlined their business models, with some deciding bond markets offer insufficient profits, a trend that has been most severe in the market for corporate bonds. "My gut feeling is that in a couple of years it could leave us with less rather than more liquidity," Stheeman told Reuters after the DMO set out its bond sale plans for the next financial year following Chancellor George Osborne's annual budget. "We keep an eye out for this. A well-functioning liquid bond market is absolutely core to what we do. If not, we have a much more challenging world into which to sell our debt." The big swings in gilt prices in the first two months of 2015 -- as markets repeatedly reassessed when the U.S. Federal Reserve would start to raise interest rates -- could offer a taste of the year to come, Stheeman added. The DMO said on Wednesday that it would need to sell 133.4 billion pounds ($196.3 billion) of gilts next year to finance Britain's budget deficit, up from 125.9 billion pounds in the financial year that finishes at the end of this month. Although Britain has halved its budget deficit since 2010, at 5 percent of gross domestic product, it is still one of the largest of any advanced economy. Net public debt is forecast to hit nearly 1.5 trillion pounds this year. The large amount of debt to be refinanced is one reason why the DMO plans to issue 28 percent of debt with a maturity of more than 15 years over the coming year, up from 27 percent over the past 12 months. Another cause is the historically low level of yields at which the DMO is able to sell the debt, with 30-year yields below 2.4 percent late on Wednesday. In late January 30-year yields hit a record low of 2.04 percent. "We are at the most extraordinarily low levels ... and there is a sense that that is something the government is very focused on," Stheeman said. The European Central Bank's bond purchase programme has depressed yields available on euro zone debt, and Stheeman said there was anecdotal evidence that overseas investors could be more willing to buy longer-dated British bonds than in the past. British government debt has a much longer average maturity than that of other advanced economies and long-dated gilts are overwhelmingly held by domestic investors such as pension funds. Stheeman said investors should not assume the DMO would increase indefinitely the share of its issuance which is made up of longer-dated debt. As borrowing needs fall, the pressure to reduce the amount of debt that had to be rolled over each year would decline. Changes in the relative price of short- and long-dated gilts could also alter the value offered by long-dated issuance. (Editing by Mark Heinrich)