The UK Government has a long shopping list and we’re not clear where this funding will come from as key investors are set to downsize gilt holdings in coming years.
We expect these market dynamics to have implications, including:
- Gilts will need to offer 'value': government borrowing costs may be higher moving forward than they’d otherwise be.
- Volatility = opportunity? Yields will (continue to) be volatile moving forwards and shrewd investors may be able to find value.
- The Government may continue to roll back on cash spending. This could create more room and more opportunities for private capital to make a return (possibly with non-cash incentives from the Government to sweeten the deal).
Talk to your advisers – what are their views on the UK gilt market?
If you’re an investor holding gilts for risk management purposes it doesn’t mean that that’s become a bad idea – gilt yields move for many reasons outside those discussed in this article and holding gilts still protects against unwanted volatility.
The UK Government's shopping list includes:
- helping fund a net-zero transition (notwithstanding changes to timelines)
- aging population with a social care system struggling to cope
- crumbling infrastructure (literally in some cases)
This is reflected in Office for Budget Responsibility (OBR) forecasts for government borrowing: a much higher average level than pre-pandemic. But where’s the money coming from?
The Debt Management Office (DMO) projections of government borrowing
Who has historically funded the UK Government?
The Government borrows by issuing bonds. Based on ONS data, gilts seems to be owned by a diverse group of investors, with three main players:
- The Bank of England – through quantitative easing.
- Insurers and Pension Schemes – who buy gilts to help stabilise actuarially calculated funding positions, encouraged by regulation.
- 'Overseas' – often interpreted as overseas institutions, like central banks or sovereign wealth funds.
So, the Government has a good diverse funding base?
Well. ONS data is based on each gilt owner’s domicile with no 'look through' the legal structures. Which isn’t necessarily where the 'economic owners' are.
Many investors use pooled investment funds domiciled in Ireland or Luxembourg, or insurance-wrapped contracts (categorised under 'other financial institutions') to purchase gilts rather than buying directly.
When you start to dig into the detail, it turns out that many of the gilts the ONS tallies under 'Overseas' or 'Other financial institutions' are actually owned by UK DB pension schemes. And most of the 'Insurance and pension funds' is DB pension schemes as well.
Not such a diverse market then:
Who owns UK gilts?
Source: ONS, Schroders, investment managers and LCP research
Ok, so what?
The demand from UK pension schemes has made the UK gilt market look quite odd vs other government bond markets. The DMO issues debt where there is market demand and UK DB pension schemes want: long-dated bonds (to match long-dated liabilities) and inflation-linked bonds (to match inflation-linked liabilities).
This has skewed the UK market: it issues far more long-dated and inflation-linked debt than most comparable bond markets. The market isn’t catering so well for other investors (yet).
Market value of govt debt by maturity date
Govt debt - % inflation linked (market value)
Source: LSEG Datastream
Not only that, the BoE and DB pension schemes are not as price sensitive as other investors. They largely hold the assets as a matter of policy, or to reduce the risk of funding positions (gaps between asset values and liability values) worsening.
Not only that, the BoE and DB pension schemes are not as price sensitive as other investors. They largely hold the assets as a matter of policy, or to reduce the risk of funding positions (gaps between asset values and liability values) worsening. As a result, for years both have hoovered up gilts at sometimes eye-watering prices.
This has helped keep UK Government funding costs relatively lower and more stable than they may have otherwise been.
Comparing UK and US Government forward yield curves
A forward curve can be thought of as a graphical representation of future interest rates as implied by market pricing. Where the implied rates seem detached from economic reality, it could indicate distortions due to supply and demand (for example strong demand from price insensitive buyers outweighing supply of bonds).
In 2007, before the global financial crisis, the UK and US had similarly shaped forward yield curves, relatively 'normal' shapes.
One way investors could interpret the forward yield curve is as a forecast of future policy rates. We'd argue that yields at the long end of the curve are more driven by supply and demand however.
The UK began issuing ultra-long government bonds in response to increasing demand from DB pension schemes. These bonds were bought at prices that caused long-dated forward rates to fall to very low levels.
You can already see that the long-dated yields are low vs the rest of the curve. Predicting a rise and fall in interest rates? Or strong demand from pension schemes?
The trend continued, causing long-dated UK forward yields to fall well below US equivalents, and with a shape that’s hard to reconcile with potential future economic scenarios (even setting aside wider factors affecting the UK economy). One explanation is pension scheme demand.
Continued strong demand from UK pension schemes (arguably) helped perpetuate this trend and led to more and more extreme yield curves. A pretty good deal for the UK Government! But can it last?
Source: LSEG Datastream
Pension schemes and the BoE have funded a lot of government spending over recent years. That’s ok – they’ll keep buying, won’t they?
DMO issuance, overlaying buying and selling from the BoE and UK DB pension schemes
Source: DMO, BoE, LCP research and estimates
They have been the key buyers, by our estimates. But will they keep buying? We don’t think so because:
1. The BoE’s pursuing Quantitative Tightening means gilts on the BoE balance sheet need to be sold.
2. We don’t think DB pension schemes will pick up the tab either – in fact they are likely to be net sellers too over coming years.
The OBR acknowledged in its July 2023 report that “The great majority of schemes are now either closed to new members or closed to the accrual of new pensions… supply of future inflows is diminishing at the same time as DB members retire and the schemes begin to pay out”, but we think the pace of reduction in pension scheme gilt holdings is likely to be much faster than that the gradual decline this implies.
The reason for this is less obvious:
- Pension scheme hedging and hence gilt buying has (mostly) peaked and there’s very little accrual of new benefits. There will be some buying but don’t expect it at scale.
- Pension schemes are 'buying-in' – passing assets and liabilities over to insurers. In practice most insurers hold far less gilts (as a % of assets) than pension schemes. Which means each 'buy-in' should be expected to result in a net sale of gilt holdings.
The de-risking market has never been hotter as rising yields have brought many pension schemes in range of transactions. This means that pension schemes may well be big sellers over coming years, potentially very big sellers.
How will the UK government continue to borrow?
The BoE and DB pension schemes won’t fill the gap, but there’s a price for everything.
Other institutions (domestic and overseas) could step in and buy – after all the UK remains a large developed economy with its own currency and many things going for it*.
However, these investors won’t be price insensitive, they’re going to want an appropriate return on their investment. They also probably won’t want ultra long-dated debt, meaning issuance will need to be more at the short end (like many other countries) and that interest costs will be more sensitive to monetary policy. So the UK Government will have to learn to cope with higher and more volatile financing costs than it has been used to.
To relieve this pressure, the Government might decide to ‘encourage’** different asset owners to start purchasing gilts, such as the UK insurance sector, banks or even retail investors.
*probably… **potentially more stick than carrot for the institutions
Find out more...
Hear more on the topic from LCP's Steve Hodder at our 2023 Investment Conference.