Debt raised through the GGB's was competitively priced

11  In advance of the issue of the tranche of GGBs in 2002, the banks arranging the issue for LCR opened an order book for the bond. While the GGBs would have a 50-year maturity, the basis of their pricing was the yield22 demanded, by the capital markets at the time of sale, for an existing 30-year benchmark gilt, maturing in 2032 and for which the Government paid interest at 4.5 per cent plus a credit margin. LCR, through its arranging banks, invited investors to place provisional orders for the GGBs at different prices, which if fixed at the time of its sale, would offer them a return of between 0.40 and 0.45 per cent above the yield rate demanded by the market for the benchmark gilt. Provisional orders came from over 100 investors, with demand exceeding supply by over a factor of four. LCR repeated the exercise, but this time reduced the margin over the benchmark gilt to 0.32 per cent. The number of interested investors fell to 63 and their combined provisional orders exceeded supply by a factor of about 2.5. At this point LCR closed the book and proceeded with the sale. RBC Capital Markets expressed the view that it was possible that LCR was advised that it would have been at risk of losing a large number of potential investors had it tried to reduce the margin further.

12  Concurrent with the investigation of market interest, LCR embarked on a market management exercise. The aim was to preserve an orderly market and avoid erratic movements in the price of the benchmark gilt which can happen as a result of investors selling gilts and other comparable financial instruments in order to buy the new GGBs. Since market price of a bond and its yield are inversely related, a drop in price of the benchmark gilt increases its yield which in turn increases the interest rate that LCR would have to pay. To counter the risk, LCR, in advance of the GGB issue, sold £700 million of the benchmark and comparable gilts that it did not have, with a promise to supply these to the purchasers at, what was then, a future date. LCR was therefore a ready buyer of gilts when the GGB issue was sold. RBC Capital Markets reported that LCR's market management exercise seemed to have been successful. At the time of the GGB issue, the yield of the benchmark gilt stayed within reasonable bounds of its then current trend and it did not trade out of line with other long dated gilts (Figure 24).

13  When LCR sold the GGBs, the market price for the benchmark gilt equated to a yield of 4.78 per cent. The interest rate on the GGBs is therefore 5.1 per cent of the face value of the bonds, the increase equalling the margin of 0.32 per cent agreed during the building of the order book. In the four months following the issue, the GGBs, in comparison to the benchmark gilt, traded close to the margin set in the book building exercise (Figure 25). This suggests that the market did not consider that the GGBs had been mis-priced.

_________________________________________________________________________________

22  Yield of Bonds - The rate of return an investor earns on a Gilt or bond, which takes into account the price the investor pays, the gross coupons payable, its maturity and the redemption amount is known as the gross redemption yield (GRY).

The price of the Gilt or bond is a function of the GRY. It is the sum of the present value of all the future cashflows, discounted at the GRY. Therefore, when the GRY goes up, the price goes down and vice versa.