Seven problems with gilts investors need to know about

The Spring Budget shone the spotlight on the UK stock market. Through a new British Isa, the chancellor is hoping to channel more investment into UK equities, delivering a much-needed boost to the domestic market.

Bonds, by contrast, were neither the subject of any exciting new policy announcements nor the headlines that followed.

But the gilt market still loomed large: each announcement in the Spring Budget was viewed through the lens of the chancellor’s fiscal ‘headroom’ – and how the bond market might react. The havoc that followed the 2022 'mini' Budget is still fresh in the memory, and today’s fiscal rules are a hangover from that time. 

A closer look at the forecasts and costs that accompanied this year’s Budget were highly revealing, too: debt levels will remain elevated – and so will the cost of servicing it. The UK stock market might be flagging, but the bond market is facing problems of its own. 

Problem 1: Both borrowing and debt are high by historical standards 

Since he took the helm in 2022, chancellor Jeremy Hunt has bound himself by fiscal rules placing limits on debt as a proportion of gross domestic product (GDP) and government borrowing on a five-year rolling basis. 

When the government spends more than it raises, it needs to borrow. It does this on a large scale through various types of gilts (and on a small scale through NS&I). A Treasury with ambitious spending plans needs to issue a lot of gilts: economists estimated that Liz Truss’s doomed 'mini' Budget plans would have increased financing requirements by over £70bn.

Thanks to the fiscal rules – which state borrowing must not exceed 3 per cent of GDP by the fifth year of the forecast period – the Spring Budget did not deliver the same kind of upside surprise. But today’s borrowing requirement is still very high: at £265bn, it represents a 12 per cent increase on the current fiscal year, and almost a 50 per cent increase on the 2010-20 average. And all of this borrowing will add to our government debt. 

This debt is, in simple terms, the stock of all of the nation's past borrowing. Thanks again to the chancellor’s fiscal rules, government debt as a share of GDP is expected to be falling in five years' time. But as the chart below also shows, the stock of debt is expected to remain huge by historical standards. 

This causes two problems. The first is that it gives the government limited room to manoeuvre. When public finances are stretched, there is less space to accommodate economic shocks, let alone deal with longer-term economic challenges. Secondly, the higher the stock of debt, the greater the costs of servicing it. According to the Office for Budget Responsibility's (OBR) latest forecasts, debt interest spending will hit 3.4 per cent of GDP, equivalent to over 8 per cent of total government revenues, by 2028-29 “due mainly to the rising stock of debt”. 

Problem 2: What to do about index-linked gilts

Not all gilts are created equal. When the Treasury raises billions of pounds, it needs to think carefully about what kind of gilts to issue. Getting the balance right matters: bonds that mature in a relatively long period of time offer protection from sudden changes in interest rates, but the government also needs to make sure that it has access to a deep and liquid bond market. As the chart below shows, issuance tends to be split between short, medium, long and index-linked gilts (where debt payments are linked to inflation). Linkers now make up around 11 per cent of total issuance – far less than in previous years. 

In the UK, around a quarter of total government gilts in issue are index-linked – far higher than elsewhere. The question of how much index-linked debt to issue today is particularly vexed. Demand for these bonds is high, meaning that they play a role in diversifying the UK’s investor base. It also gives the government very real skin in the game when it comes to delivering on low and stable inflation, boosting credibility. 

But this kind of issuance has also intimately linked public finances to inflation shocks – and increased debt interest spending substantially. The OBR estimates that as inflation peaked in 2022, debt interest spending reached a post-war high of 4.4 per cent of GDP.

Inflation-linked bonds also make forecasting the public finance position more challenging. The OBR’s latest stress tests suggest that if retail price index (RPI) inflation is 1.3 percentage points higher in 2028-29 than forecasts currently suggest, the chancellor’s headroom will fall to zero. This seems eminently possible: it would represent an upward shock just one-tenth of the size of the inflation surprise we experienced in 2022-23.

Problem 3: Higher debt servicing costs mean less to spend elsewhere

In December last year, OBR chair Richard Hughes highlighted a core problem with the government's high levels of debt. He noted to the House of Commons public accounts committee that higher interest rates meant the cost of servicing this borrowing was limiting the ability to spend (or cut taxes) elsewhere.

A small change in the inflation rate could see the chancellor’s headroom ‘disappear’, and so could an even smaller fluctuation in interest rates. The OBR warns that if effective rates on government debt were just 0.3 percentage points higher, they would eliminate the chancellor’s headroom entirely. If they were 0.3 percentage points lower, they would double it. Again, this kind of deviation from the forecast looks entirely plausible. Expectations for Bank rate in 2028 have swung between 2.7 per cent and 4.2 per cent over the past few months alone. 

Problem 4: Markets have to absorb a lot of supply

The government’s plans to issue £265bn of debt are only half (well, three-quarters) of the story. Thanks to quantitative tightening, UK bond markets will also have to absorb an additional £100bn of sales per year. 

This means that the supply of gilts is currently very high: comparable with the levels seen during the pandemic and the financial crisis when the government financed the huge gaps between its tax receipts and spending needs. This volume may have historical precedent, but it’s not usually sustained for long periods of time. 

The good news is that the market seems to be holding up well. The OBR’s Hughes says that “so far, a combination of fiscal policy recovering from a pandemic and monetary policy trying to unload [bonds] as a tool of monetary policy has not put undue pressure on gilt markets”. 

But after the Spring Budget, Imogen Bachra, head of non-dollar rates strategy at NatWest, warned that the heavy supply outlook could remain “problematic” for gilt yields. In theory, high supply will put downward pressure on prices, with yields moving inversely. As a result, Bachra thinks that rate cuts might not have the same impact on bond yields as they would in a usual cutting cycle. She expects 10-year yields (usually seen as a good proxy for government borrowing costs) to rise back up to 4.25 per cent, as rate cuts fail to exert their usual  “gravitational pull” on yields. 

Problem 5: The government doesn’t issue much debt directly to UK households 

The UK has traditionally relied very sparingly on retail investors to buy government debt directly. In the UK, gilts tend to find their way into people’s pension funds, whereas countries like Italy see a lot more direct issuance to households. NS&I products (Premium Bonds and savings accounts) make a modest contribution to government financing, at around £7.5bn last year.

Though slight, it is still important. Hughes stressed last year that “it is always good to have several routes into the market”.  But to help find buyers for the huge supply of gilts, the Treasury is trying a new tactic. Investors can now buy new gilts in the primary market via selected investment platforms, with transactions facilitated by Winterflood Securities. Until this year, investors had to buy gilts in the secondary market. Hargreaves Lansdown said that the new offering came “in response to the notable surge in client demand for gilts within the secondary market”, and told the IC that demand was “five times higher” than expected. 

Problem 6: We rely heavily on overseas investors

Although we have very thorough data on what kind of debt is issued (see chart 1), we have far less clarity on where it actually goes. About a quarter of UK government debt is held overseas, and some economists worry that this is a problem. According to the OBR’s Hughes, domestic investors tend to be less “flighty”, especially defined-benefit pension funds which look for sterling assets to match their sterling liabilities and hence are major holders of UK gilts. But Hughes warns that as these schemes get close to being fully funded, and as their liabilities move into payment as more people in the scheme reach retirement age, demand from the domestic pension fund sector will fall. 

This means that “we are more likely to have to keep looking to foreign markets” to absorb the higher supply of gilts. Hughes notes that “by their very nature, foreign investors are less committed to holding sterling assets”, and could easily move into other markets if higher returns are available elsewhere. 

Problem 7: Bond vigilantes are back

UK gilt yields soared in response to Liz Truss's fiscal plans in 2022; investors doubted the ‘investability’ of the UK economy and demanded a higher interest rate in compensation. After all, if foreign investors see gilts as a substitute for US Treasuries or German bunds, the relative performance of the UK economy really matters. 

After the Spring Budget, markets were largely flat. But Kaspar Hense, senior portfolio manager at RBC BlueBay Asset Management, warned against complacency. “With the recent years of high inflation, bond vigilantes have awoken and will not be put to rest easily. This leaves the government more vulnerable,” he said.

This leaves the government grappling with the more fundamental question of whether the UK economy is somewhere that people want to invest. The short-term economic indicators are pointing in the right direction again: inflation is cooling and there are hopes that the recession is already over. But over the longer term, productivity and inactivity remain huge concerns. The Spring Budget took a step in the right direction – but the next government has a long road ahead.