Everyone knows of Harold Wilson’s quip about a week being a long time in politics. Lately, a week has often seemed a very long time in the market for gilt-edged stock, too, such have been the wild changes in the price of securitised government debt. And, just as a good old-fashioned sterling crisis back in 1964 prompted Wilson’s famous remark, crises often not far removed from the value of sterling have triggered the market’s swings in the past 12 months.
Chart 1 shows these ups and downs via the inverse symmetry of the price and yield to maturity of Treasury 4.25 per cent 2032, a benchmark gilts stock that started out as long-dated when it was issued in 2000 and is now at the short end of the market’s medium-dated stocks.
The price and yield of fixed-interest stocks move inversely; as one rises, the other falls and vice versa. Sometimes one factor is the driver, sometimes the other. In the major movements shown in the chart, the changes seen during last year’s spring were driven by price. The value of almost all assets fell in response to Russia’s invasion of Ukraine, thus raising gilt yields to accommodate both higher inflation and extra uncertainty.
The chart’s most dramatic phase last autumn was also driven by price. The horrified response of investors to the Truss/Kwarteng kamikaze Budget in September was to dump government stocks (and sterling), causing interest rates and gilt yields to soar. At other times – and especially in recent months – rising interest rates have driven falling prices as the Bank of England, much like central banks throughout the developed world, has responded to inflation-inducing demand in the only way that it can – with higher base rates.
The net result of events of the past 12 months is that the yield on government stocks is higher than it has been since before the financial crisis of 2008-09, which ushered in the longest period of near-zero interest rates since the Bank of England was founded in 1694. As we write, the yield to maturity of Treasury 4.25 per cent 2032 is 3.2 per cent. Compared with levels as low as 0.2 per cent less than two years ago, that represents both a rate that has risen faster – admittedly from a minuscule base – than in any period previously and, at its current level, has a feel of reality about it.
Perhaps, but don’t get too excited. As Chart 2 shows, current yields on conventional fixed-rate gilts may seem more sensible than the crazy-low rates that persisted until recently, but they are still likely to offer investors a loss in real terms. Let’s remember that current redemption yields on, say, 10-year gilts of generally between 3.5 per cent and 4 per cent compare with UK inflation rates clear of 10 per cent. What sort of bargain is that?
Granted, Chart 2 exaggerates to make the point. It juxtaposes gilt yields with the UK’s retail price index (RPI) inflation, a measure that its provider, the Office for National Statistics (ONS), disapproves of because the underlying maths used in its calculation is faulty. Despite the disapproval, the RPI – currently running at almost 14 per cent – is arguably the inflation rate that matters since it is the one to which payments of interest and principal on UK government index-linked gilts are tied.
Another valid objection might be made about the chart – namely, that it is wrong to compare current inflation rates with gilt yields. That’s because inflation is always a backwards-looking indicator; it relies on prices that were paid until recently. Gilt yields are forward-looking; they mostly measure the average inflation rate investors expect over the remaining term of a stock. That’s true. But, over the long haul, the juxtaposition of these two rates – inflation and gilt yields – gives a good indication of whether or not investors are likely to be compensated or penalised for holding fixed-interest government stock.
Penalised, is the verdict for most of the recent past. As Chart 2 indicates, there was a golden period in the early 2010s as gilt yields topped inflation rates that came in below the Bank of England’s 2 per cent target. But, both before and after, that was more the exception than the rule. The chart also shows that pretty much from the moment the UK’s electorate voted for Brexit in mid-2016 inflation started to run at rates well above gilt yields. Since late 2020 the gap between the two has been such that, somehow, inflation would have to undershoot gilt yields both substantially and consistently for investors who hold stocks to maturity to have any chance of making acceptable returns.
Put simply, that’s not going to happen. It is not just that no one believes it when Andrew Bailey, the governor of the Bank of England, protests that UK inflation will be close to the central bank’s 2 per cent target by the end of the year. More important is the state of the UK’s public sector finances, the effect this will have on the government’s need to borrow and on the cost of the debt it raises.
Public sector net borrowing at record highs
Take a couple of headline points from the ONS’s latest review of the public sector accounts. In February, public sector net borrowing ran to £16.7bn. This was more than twice the level of the previous February and the highest since monthly records began in 1993. Similarly, total public sector debt – £2.5tn at the end of February – was at its highest level in relation to national output (gross domestic product, GDP) since the early 1960s.
Granted, a chunk of the government’s recent spending is supposed to be temporary. Government subsidies, much of which relate to energy support schemes, ran to over £24bn in the three months to end February. These should fall away in the coming months. Meanwhile – and ironically – high inflation is pushing up the cost of servicing government debt because of the connect between RPI and index-linked gilts. In December, interest payments cost the government £18bn, more than double the amount for December 2021. Since index-linked costs are tied to RPI lagged by three months (so, for example, February’s costs reflect changes in inflation between the previous November and December), high inflation will continue to raise the cost of government debt at least until the end of the year.
If the short-term outlook for public sector finances is glum but perhaps a little less glum than a few months back, the same can be said for the longer-term view. The Office for Budget Responsibility, which is caricatured as the government spending watchdog, suggests that higher interest rates mean the costs of servicing government debt will absorb increasing amounts of government spending. Rising from 3.1 per cent in 2020-21 to 7.8 per cent in 2027-28, the limit of its forecast horizon. By that time public sector debt relative to GDP will have dipped slightly from its peak of 97.8 per cent the year before.
The decimal points in these forecasts are meaningless, as a few percentage points may also be. But the underlying point is that the UK government will have no choice but to continue tapping the UK’s savings capacity big time, plus overseas capacity, too.
Chart 3 takes a long-term view of this dilemma. It shows government debt relative to GDP since 1900. True, in relation to the levels that persisted from the middle of the first world war until the early 1960s the current debt-to-GDP ratio looks like nothing to be concerned about. However, that misses the point. The horizontal line puts the current level into context by estimating the average ‘peace-time’ ratio; ‘peace-time’ defined, somewhat arbitrarily, as the average ratio for the periods starting two years after each war began and running until 10 years after each ended (ie, 1916-28 and 1941-55).
The point is that currently the ratio is well above the average, has been since 2010 and will continue that way for who knows how long. This is not a happy prospect for investors in gilts, made more miserable by the likelihood that a major source of demand is fading away. Defined-benefit pension schemes used to be big holders of gilts when stock yields were high enough that their holdings produced enough cash flow to cover their liabilities (basically, cash in will cover cash out). Increasingly, however, defined-benefit schemes are in actuarial surplus, which means that employers, who have ultimate liability for them, can sell them, usually to insurance companies whose own regulatory requirements now mean they are less likely to hold gilts.
Arguably worse than that, the Bank of England is now also a big seller; in effect, dumping more stock on the market. The central bank is a massive holder of gilts – about £715bn-worth out of about £2.3tn-worth of stock outstanding. These holdings – built by the process of so-called ‘quantitative easing’ – were bought during the financial crisis of 2008-09 and then again during the Covid lockdowns. Now, however, quantitative easing is turning to quantitative tightening. Sure, the process is tentative and it is uncertain whether the bank will cut its holdings by its intended £80bn a year. Even so, to some extent – greater or lesser – this process must depress prices and expand yields.
In all these circumstances, which investor would happily hold conventional fixed-coupon gilts? There is always a place for them in a portfolio to the extent that their price changes have low correlation with equities. Depending on their coupon – the pre-set amount of interest they pay based on £100-worth of stock – they will be comparatively resilient as interest rates rise and will offer predictable gains when rates fall.
Each investor’s tax rate is also a big factor. For private investors, interest received is taxed as income while any capital gains are tax-free. That feature might make, for example, short-dated Treasury 0.625 per cent 2025 attractive to top-rate taxpayers even today. At its current £94.30, most of the stock’s 3.4 per cent redemption yield will be via a capital gain rather than income. This factor also discriminates against high-coupon stocks, such as Treasury 5 per cent 2025 since, priced at £102.54, its 4.9 per cent income yield will be trimmed to a 3.6 per cent redemption yield on maturity in two years’ time.
Sure, if UK inflation does drop to its 2 per cent target in the next year or so and remains thereabouts, then redemption yields of 3.7 per cent or so on medium-dated stocks might be acceptable; especially an ultra-low coupon stock such as Treasury 0.625 per cent 2035, most of whose 3.6 per cent yield, at a price of £70.50, will be via a tax-free return of capital in eight years’ time.
That said, it is pretty plain that the bullish action in gilts will be when markets become confident interest rates are heading downwards. Since it is not yet clear they have even peaked, that might not be for quite some time.
