When the government spends more than it receives in taxes, it needs to borrow money to make up the difference. Like everyone else, what the government pays to borrow changes and, as Liz Truss and Kwasi Kwarteng found out in late 2022, this can happen very quickly1.
In this post we will explore what causes the cost of government borrowing to change, why the government can’t fully control this and why this matters for institutional investors and everyone else.
Who lends to the UK government?
Millions of us lend to the government, either directly through British Savings Bonds or Premium Bonds or, more commonly, by owning assets called gilts in our pension plans or personal investments2. Large institutions like defined benefit (DB) pension funds and insurance companies also own £hundreds of billions of gilts, and are therefore one of the largest lenders to the UK government3.
A gilt is a type of loan. When investors buy a gilt they are lending money to the UK government in return for interest payments known as coupons. If an investor holds onto the gilt until it’s repaid by the government, at what’s known as the maturity date, they will know the return they will earn (known as the yield) in advance, as long as:
- the government makes all the coupon payments,
- the government repays the gilt on the maturity date and
- the investor holds onto the gilt until the maturity date, rather than selling it onto another investor.
If the government chooses not to make all the gilt payments or is unable to, the investor will lose out. This is known as a default, although the risk of this is extremely small for the UK government.
What the government pays to borrow
The chart below shows the 10-year gilt yield – in other words, the annual interest rate the government would have to pay to borrow for 10 years – since 2020.
Today, the 10-year gilt yield is about 4.6%, but it has varied a lot over the last five years, and is now about as high as it’s been since the pandemic.
The higher the interest rate, the more expensive it is for the government to borrow and the less money it has to spend on other things (unless it borrows even more or raises taxes).
Why the government can’t control what it pays to borrow
The interest rate on gilts is decided by financial markets and depends on several things.
The creditworthiness of the government
Firstly, how likely is the government to repay investors? This isn’t a big consideration for gilts, as most investors believe the UK government is extremely unlikely to default on its debt. This can be more of a concern when lending to the governments of less developed economies though. These governments usually have to pay a higher interest rate to compensate.
Supply and demand
However, how much debt the government has – and is expected to have in the future – does matter. After the infamous mini budget in September 2022, when the government announced a raft of largely unfunded tax cuts, gilt yields spiked dramatically. This was not because investors necessarily believed the government would be unable to repay its debt; it was because investors expected the government would need to borrow much more to pay for the tax cuts.
Like any asset, a large increase in the supply of gilts will weigh on their value. Therefore, if investors think the government will need to borrow more in the future, they will demand a higher interest rate to compensate.
The demand for gilts also matters. The government has less control over this. As noted above, institutions are one of the largest buyers of gilts. They buy them to diversify their return sources, as bonds usually perform very differently to assets like equities (shares of companies), that are more sensitive to the economy. Gilts are also what’s known as a “matching asset”, which we’ll return to in a future post. If the demand for gilts from institutions falls, this will make it more expensive for the government to borrow.
The interest rate set by the Bank of England
It also matters how lending to the UK government compares to other things investors could do with their money. For example, rather than buying a 10-year gilt, investors could hold onto cash for 10 years. In the UK, the interest rate on cash is closely linked to the interest rate set by the Bank of England – the so called “base rate”. If the Bank of England raises the base rate and investors think the Bank of England will keep it raised, holding onto cash will become more attractive relative to gilts. Interest rates on gilts will then need to rise to compensate.
The Bank of England is independent to the UK government so, although the Bank of England will set the base rate in response to things like inflation and economic growth, which the UK government does have some control over, the government can’t control the base rate itself.
The economy
Also, rather than investing in gilts with their fairly predictable but uninteresting return profile, investors could buy equites, which carry higher risk, but also higher potential rewards. Investors are more likely to do this if they are feeling positive about the state of the economy, as this is good for companies (and therefore share prices). Conversely, if investors are worried about the economy, then they may prefer the relative safety of gilts, which will mean the government can borrow more cheaply.
Inflation
Finally, most gilts make fixed repayments. The purchasing power of these payments will erode over time due to inflation. This means that investors will also require a higher interest rate if they think inflation will be high. (Note that there are also gilts that make inflation-linked repayments – index linked gilts.)
So, in summary, the interest rate the government must pay on its debt depends on:
- The creditworthiness of the government.
- The supply and demand for gilts.
- The interest rate set by the Bank of England and what investors think it will be in the future.
- How positive or negative investors are on the economy.
- Investors’ inflation expectations.
Why does this matter?
Gilt yields are critically important to UK institutional investors. In the last post we discussed how the cost of the pensions promised by a DB pension fund depends on the return the pension fund expects to earn on its investments. Gilt yields are a key component of that return, so volatile gilt yields make the cost of funding a DB pension fund unpredictable. Pension funds manage this unpredictability using a technique called Liability Driven Investing (LDI), which we’ll cover in a future post.
The cost of several financial products and services used by individuals also depends on the interest rate on government debt. Mortgage rates and the cost of buying an annuity in retirement are two examples.
The five factors described above are increasingly global and the government can only influence them partly. Therefore, issuing too much debt is not just a problem for the government because it increases the cost of borrowing. Issuing too much debt also exposes the UK’s finances to the ebbs and flows of the global bond market. Since 1997, UK governments have set “fiscal rules”, to control the level of government borrowing. Of course, whether they have stuck to them is another matter.
The issues above also apply to individuals. Clearly, having too much personal debt will make it more expensive for us to borrow. It also makes our personal finances more unpredictable as, like the government, the cost of our borrowing rises and falls. This is not to say that debt is a bad thing. Borrowing – and its cousin leverage – are important financial tools used by institutions and individuals; they just need to be managed carefully. We’ll return to the topic of leverage in a future post.
Photo by NastyaSensei on Pexels.com
Leave a Reply