UK sells $2 bn of bonds; demand lowest in 2 yrs

Demand at a sale of 35-year UK bonds fell to the lowest in more than two years as investors bet the Bank of England is starting to focus more on supporting financial markets than tackling inflation.

The Debt Management Office, which oversees debt sales for the government, sold 2 billion pounds ($4.06 billion) of 4.5 per cent bonds due 2042 at an auction today, drawing bids 1.32 times the amount of securities on offer, the lowest since July 2005. Auctions of similar maturity debt held on June 5 and July 3 drew an average bid-to-cover ratio of 1.62 times.

The DMO discounted the price at which it sold some of the securities. The difference between the yield at the lowest accepted price less the average price was 3.1 basis points, the biggest so-called yield tail since at least 1998, data on the DMO's Web site showed.

Today's sale was the first of bonds due in more than 15 years by any major economy since world markets began tumbling in mid-August on concern losses linked to US subprime mortgage defaults will spread.

The Bank of England, after raising interest rates three times in 2007 to counter quickening inflation in Europe's second- biggest economy, last week kept the key rate at 5.75 percent.

"We are a bigger fan of short-dated bonds than longer-dated bonds at the moment,'' Ian Pizer, a portfolio manager at Standard Life in Edinburgh who oversees $265 billion in assets, said before the auction. "The Bank of England may eventually be forced'' to cut rates "to react to the problem in the money market.''

Main Threat

Bonds with maturities longer than 15 years have trailed shorter-dated debt since the Fed cut its discount lending rate on August 17 to free up lending, a move some investors have interpreted as a sign policy makers no longer consider inflation as the main threat to the economy. Money-market rates have surged since the end of July as banks hold back from lending on concern over undisclosed losses from subprime mortgages.

The extra yield investors get for holding 30-year US bonds over 10-year notes has climbed to 30 basis points, from 10 basis points at the start of the year. The so-called steeper yield curve reflects expectations inflation will accelerate.

Central banks have acted to try to counter a surge in lending rates in the inter-bank markets that has pushed up the cost of corporate borrowing. The Fed pumped almost $31.3 billion into the banking system on Sept. 6, the most in almost a month. The European Central Bank injected 42.2 billion euros ($57.7 billion) the same day.

In the UK, demand for long-dated bonds from pension funds, driven partly by regulations, has resulted in an inverted yield curve, pushing 30-year bond yields to below those of 10-year bonds. Investors typically demand higher returns for holding longer-dated debt to compensate for the increased risk that inflation may quicken and erode the value of fixed-income payments.

The spread between the 10- and 30-year bonds will have to narrow to 45 basis points or less to lure investors, Pizer said.