When the UK government found £1 billion for Northern Ireland to secure Democratic Unionist parliamentary support, critics accused it of turning to the same “magic money tree” it had previously mocked others for believing in.
But it may just be that the tree is flourishing in plain sight. UK national debt is currently issued at a yield of less than 1% – far below the rate of inflation (2.6% in July). And this means Britain can effectively raise money free of charge in real terms.
On paper, this is a golden age for gilts, the bonds issued by the UK Treasury named after their certificates’ gilded edge. The government’s cost of borrowing, as measured by yields on those gilts, has fallen steadily from more than 12% in the early 1990s to less than 1%.
Economic slowdowns, political shocks, the 2008 global financial crisis, and the Brexit referendum vote have all failed to arrest the decline. In July 2017, £2.75 billion worth of five-year government bonds were offered at an interest rate of just 0.75%, and buyers still demanded more than three times the amount on offer. High demand lifts the prices of bonds and so compresses their yield, which is the regular interest payment expressed as a percentage of the price.
Behind the boom
The fall has continued despite factors that would normally have scared buyers and forced yields higher to attract investment. These include the UK’s ever-rising debt: it is now at 86% of GDP, up from 36% in 2007, caused by a budget deficit that started to widen again this year. A slowdown in GDP growth (to just 0.3% in the second quarter – half that of the euro zone) makes it harder to cut the deficit and debt as a percentage of GDP. Investors are also looking past the threat of persistently higher inflation, which gives gilt buyers a negative real return on their investment at current yields.
The ongoing slide in the value of the pound further dents the potential returns for overseas investors. For many, Daniel Craig has provided the only genuinely positive return on a British Bond in recent months.
So why are UK bonds still flying off the shelves, allowing the government to plug the gap in its spending plans with virtually “free” money? It is possible that investors are snapping-up new gilts simply through a lack of alternatives. If (as some fear) overpriced stock markets and property are about to crash and once-buoyant emerging markets are in trouble then the public debt of stable rich countries becomes the least worst option. US and German debt issues are proving similarly popular at rock-bottom yields.
Some see more positive forces driving up demand for Treasury debt and keeping its costs down. Booming bond sales, say supporters of chancellor Philip Hammoond, may be a vote of confidence in Britain’s prospects for long-term growth and low inflation, bolstered by a strong tax base and innovative skills. Foreign appetite for gilts, unquenched by the triggering of Article 50, might endorse the government’s view that the UK will emerge stronger from Brexit.
Against this, bond demand may have been bolstered by more negative, less stable factors. Yields have been held down by the Bank of England’s “quantitative easing” (QE): a programme of buying up old government debt so that more investors compete for new issues. Launched in 2008, QE has had to be prolonged because of a slump in UK growth rates since mid-2015 and the prospect of renewed deflation (falling prices) once the present round of cost increases due to a weakened currency has passed through.
Who’s holding the debt?
Traditionally, around 40% of UK public debt was held by pension funds and insurance companies, which form a captive market because of their need for predictable and safe long-term investment returns. Around a quarter was held by other UK financial institutions and households, and the rest by overseas investors.
QE has disrupted this pattern. Now, around a quarter of issued gilts are held by the Bank of England under its Asset Purchase Facility. Official data still show overseas holdings at around 27%, with insurance and pension funds’ share down to 28%, and other UK financial institutions holding around 40%. But once the store of gilts sequestered on the Bank of England’s balance sheet is excluded, overseas buyers account for 35% of gilt holdings and other central banks another 11%.
Uniquely, more than 10% of the UK’s debt cannot be traced to either domestic or overseas buyers due to the paucity of data from the regular auctions. Lack of clarity on who’s holding the debt makes it harder to judge the risks of buyers selling-off or staying away. That fuzziness that may have helped to keep the markets calm.
Gilt yields’ 25-year descent has been punctuated by upward spikes as demand suddenly dips. Each time, a respectable subset of investors and economists pronounce the end of the boom, but so far, such panics have quickly faded. Ironically, the UK may have boosted its “safe haven” status even while stirring up global uncertainty through its Brexit vote.
The Bank of England’s policy of purchasing and holding public debt – extended after the referendum result – serves to underpin prices by keeping debt off the market. But with central bankers under growing pressure to end QE at their annual gathering in August, there are fears that its eventual resale could cause prices to slump and yields to jump. Some investors may even be gambling on the Bank simply cancelling the bonds it holds to avoid such a crash.
An undimmed appetite for UK debt, even with its yields at historic lows, has undoubtedly taken the pressure off Philip Hammond as he plans this autumn’s Budget. If the deadline for restoring budget balance – already postponed beyond 2022 – fades further from the headlines, then it may well be because the crowded debt issuance calendar has started to resemble the magic money tree’s genetic code.