* DMO faces challenge to sell record 2009/10 issuance
* DMO has support from BoE purchases, sterling weakness
* DMO uses syndicates to place less favoured gilts
* Strategists worry about UK fiscal outlook, end of QE
* Main threat is gilt price level, not failed auctions
By David Milliken
LONDON, April 22 (Reuters) - No matter how the UK Debt Management Office dishes up the record 220 billion pounds of goverment debt it has to sell this fiscal year, investors are going to struggle to digest it all without a few hiccups.
A bleak growth outlook for this year and next means that finance minister Alistair Darling revealed on Wednesday Britain will run its biggest ever budget deficit of 175 billion pounds or 12.4 percent of GDP -- requiring record gilt issuance.
After Darling presented his 2009/10 Budget, the DMO tried to make the gilts as appetising as possible, but fixed income strategists warned there was a real risk of indigestion.
"We've got an awful lot of supply in the pipeline and not much in the way of a credible roadmap to bring UK public finances onto a sustainable basis," said Richard McGuire, fixed income strategist at Royal Bank of Canada.
Gilt prices tumbled after the Budget and DMO issuance plans, which were well above what analysts had expected.
Darling forecast that public sector net borrowing would only decline fractionally to 173 billion pounds in 2010/11 and would still be at 140 billion pounds in 2011/12 -- and McGuire said the assumption of a return to growth of 1.0-1.5 percent next year looked too optimistic.
"The fiscal tightening is a drop in the ocean. It's sound and fury signifying nothing, as it were," he said.
Against this backdrop, DMO chief executive Robert Stheeman told Reuters he was confident the debt agency would have no big problems selling the requisite gilts, even if there was a risk of another failed auction like last month's for a 40-year gilt.
If demand fell, it would be reflected in higher financing costs for the government rather than an outright inability to sell gilts, Stheeman said -- a view shared by strategists who dismiss the worry of some opposition politicians that Britain could ultimately need bailing out by other countries.
In its favour the DMO has the fact that the Bank of England has committed to buying 75 billion pounds of financial assets, mostly gilts, from investors by the end of June, and may well spend another 75 billion on top of that as part of its quantitative easing programme to boost the British economy.
The BoE purchases 5-20 year conventional gilts, and the 70 billion pounds of medium-dated gilts the DMO is selling falls squarely into this category -- though Stheeman insisted this was because it was 7-15 year gilts that are the most liquid segment, rather than on account of support from the BoE.
LACK OF NERVE?
Marc Ostwald, strategist at Monument Securities, said that the focus on medium-dated gilts suggested a real lack of confidence in demand for other gilts.
"Fundamentally they are truly afraid of issuing by auction those index-linked and long-dated gilts. The 2049 failure doubtless dictated that," he said.
"If you rely on the BoE holding up demand that's rather short-sighted, because in the long run the Bank will have to sell what it has bought. And it also says that without a buyer of last resort there isn't much hope for the UK's rather messy public finances," Ostwald added.
Instead, the DMO should have issued more gilts with maturities shorter than 7 years to appeal to banks which would have to buy them to comply with new upcoming capital adequacy rules, Ostwald said.
Another tactic adopted by the DMO is to sell some of its less liquid long-dated and index-linked gilts -- which are not bought by the BoE -- to syndicates of banks rather than at an open auction.
Stheeman said this meant the DMO could achieve a better price, as traders buying gilts at auction demanded more of a discount to compensate them for the risk of holding the gilts until they could sell them to institutional investors.
McGuire said this made sense, especially for new issues of less popular gilts where it was hard to establish a price.
"Syndication is a relatively safe way of price discovery, especially for new issuance such as a new ultra long which we have speculated about," he said.
Finally, Stheeman said sterling's current weakness against the euro and dollar made gilts a good bet for overseas investors, on the basis that the currency would strengthen over the time they held the security.
But Ostwald cautioned that gilts looked overpriced over that timescale, especially a couple of years down the line when the BoE sells the gilts it has bought under its quantitative easing policy while the DMO still has a hefty issuance to sell.
"We may get a wholesale upward shift in yields," he warned. (Editing by Stephen Nisbet)