By Nigel Jenkins, managing director at Payden & Rygel
The UK gilt market forms a core part of the asset allocation of many UK-based investors, from pension funds, banks, insurance companies and corporate treasuries through to wealth managers and private investors.
Further, it forms a basis for the pricing of other important asset classes (corporate and securitised bonds, for example). Perhaps most fundamentally of all, it determines the borrowing costs of the UK government and other term borrowers in sterling. It’s an unquestionably important component of UK Inc.
Views about the stability of the gilt market and its longer-term outlook are therefore very consequential for UK entities, borrowers and investors alike. And those views are often not very encouraging.
Back in 2010, shortly after the global financial crisis (GFC), the most high-profile bond fund manager in the world at the time, Bill Gross, described the UK government bond (Gilt) market as “resting on a bed of nitroglycerine.”
See also: The fixed income funds yielding above gilts without sacrificing performance
Because of the UK’s very particular economic exposure to the GFC and the depth of the subsequent economic slowdown, the government was running a budget deficit (the gap between annual expenditures and revenues) of close to 10% of GDP. It’s about half of that today.
But on other important metrics, the current position looks more problematic than it did in 2010. Accumulated government debt is now around 95% of GDP compared to 70% then. And borrowing costs are considerably higher now (2-year gilt yields are above 4% compared to 1% then, and even 10-year yields in the 4.75 to 5% area are more than a percentage point higher now than back then).
What are we to make of these comparisons? What would Mr Gross say now? How has that nitroglycerine bed evolved over the past 16 years? Is it more explosive, or more benign?
Well, first off, we must recognise that if gilts were indeed resting on a bed of nitroglycerine, then it has not exploded over the subsequent 16 years; maybe it didn’t exist in the first place.
Successive prime ministers (Gordon Brown was PM at the time of the nitroglycerine barb; there have been six, soon to be seven, PMs in the 16 years since) and chancellors of the exchequer (there have been eight, probably soon to be nine, of those over that same period) have been able to successfully borrow in international markets.
Even through dramatic spikes in the cost of that borrowing, as happened after the fateful mini-budget of the Truss government in the autumn of 2022, which admittedly felt quite incendiary at the time.
See also: Head to head: Taking stock of gilts
Second, the UK is far from unique in having such heavy public sector deficit and debt burdens. Almost all major developed countries have seen significant increases in government indebtedness since the GFC, and most of them face a considerably higher interest rate and Government bond yield combination than they did back in 2010.
Third, lower private sector indebtedness (of both the consumer and corporates) is a welcome offset, especially given governments greater ability to fund heavy debt loads even in times of crisis.
Rather, our concerns around UK debt sustainability are focussed on:
- Weak economic growth failing to generate strong enough revenues to lower the debt burden. Especially given that medium to long term real (inflation-adjusted) interest rates (or real gilt yields) currently trade 1% or so above where we would characterise the real trend economic growth rate. This means that even in an environment of a balanced primary budget, the public sector debt load as a percentage of GDP will continue to grow.
- The reality that the UK is a relatively small player on the international stage, one that is competing with much larger debt and equity markets for marginal investment. And one that is far from impervious to international developments (economic and political) that are not in its gift to control.
- And that, related to this second point, the UK requires significant investment flows from often fickle international investors to fund its obligations. Especially given an ongoing 2.5% of GDP or so current account deficit, reflecting an excess of domestic investment over savings.
In summary, the UK is not the basket case that the more apocryphal commentaries might often imply. But our analysis does emphasise the importance of improving growth performance.
This will hopefully be a primary focus of the reformed governing Labour Party administration, likely under an Andy Burnham premiership.
And if this can be accompanied by a more even distribution of the benefits of that stronger growth, the UK might even enter a virtuous circle of improved social mobility, less voter dissatisfaction and greater political stability. Stronger real growth and lower real interest rates could co-exist and be self-reinforcing in this environment.
That gilt market bed might after all turn out to be a pocket-sprung mattress which could act as a springboard for better times ahead.
