- Index-linked bonds give governments ‘skin in the game’
- But this hurts when inflation is high
Take a look at the latest data, and you could be forgiven for thinking that index-linked gilts are nothing but a headache for Rishi Sunak's government. A report from Fitch Ratings shows that government interest payments on a 12-month basis reached £117bn in May 2023 – double the level of the period to September 2021. As James McCormack, Fitch global head of sovereigns, put it, the increase "reflects the high proportion of inflation-linked debt in the UK, which sped up the pass-through from inflation to interest costs despite the long average maturity of government debt”.
In June, the agency reiterated its negative outlook on the UK’s AA- credit rating, citing “the UK’s rising government debt and uncertain prospects for fiscal consolidation”. The agency noted that interest payments “will remain well above the projected ‘AA’ median of 2.8 per cent in 2023-24”, thanks in part to payments on index-linked debt.
The UK is far from unique in issuing inflation-linked bonds, but it does look particularly badly positioned today. Firstly, index-linked debt accounts for almost a quarter of UK government debt stock; the next largest issuer in the G7 – Italy – has just 12 per cent. The UK is also enduring a prolonged period of unusually high inflation. McCormack points out that while Brazil also has high levels of index-linked debt, its inflation is expected to average 4.7 per cent in 2023 – about the same as the average rate between 2017 and 2022. The latest forecast from Fitch predicts that the UK government will spend 10.4 per cent of total government revenue on interest this year – the highest of any major economy (see chart).
With government finances stretched and inflation elevated, index-linked gilts are starting to look like a particularly bad deal from the issuer's perspective. But the rationale for using such debt isn't entirely mistaken. Bank of America (BofA) analysts point out that “a government’s assets – land and buildings – are real, and its revenues – income, consumption and corporate tax – are real”. As a result, it can make sense for liabilities to be inflation-adjusted, too.
The analysts also suggest that index-linked debt can deliver a ‘credibility feedback’ benefit. When a government issues such bonds, it robs itself of the chance to inflate away the real value of their debt by letting inflation run high. Index-linked bonds give policymakers “skin in the game to keep inflation low” as a result. Inflation-linked debt can also prove cheaper to issue than nominal debt if investors are willing to pay extra for an inflation-protected return. In theory, then, there is a lot to like: index-linked gilts can “extinguish risk for both borrower and investor”.
But theory must square up to economic reality – and some macroeconomic backdrops are particularly difficult for inflation-linked bonds. Oil price shocks are one example: lifting inflation, while cutting growth. BoA analysts think that the pandemic and the war in Ukraine have probably had a similar impact. They estimate that the debt servicing costs of the UK’s linked liabilities made up about two-thirds of the total government interest bill in the last fiscal year – equivalent to 3 per cent of gross domestic product (GDP).
But by focusing on index-linked gilts, we could be missing the bigger picture when it comes to government debt. A recent speech by Bank of England deputy governor Dave Ramsden highlighted that the vast majority of the 300 basis point increase in the UK 10-year gilt yield since February 2022 “has been driven by increases in expected policy rates”. When inflation rises, so do interest rates, dragging government debt servicing costs up along with them.
The BoA analysts conclude that “you don’t have to believe that we will see a return to the eye-watering real policy rates of the Volcker era” to accept that stubborn inflation could drag on debt servicing costs. They suggest that the greater threat “will not be the inflation itself but the likely policy response”. High inflation has undoubtedly contributed to a difficult public finance position. But the remedy could prove as painful as the disease.
