They say that the bond market can intimidate everyone, and it has the potential to be particularly menacing at the moment. The Bank for International Settlements warns that government debt has reached “unprecedented levels in many countries” – a situation that looks increasingly unsustainable against a backdrop of slow growth and high interest rates.
Markets are not afraid to make their displeasure known. Earlier this month, gilts sold off as traders feared that a vulnerable Rachel Reeves might be replaced by a less fiscally ‘prudent’ chancellor. Warnings rumbled again last week when the Office for Budget Responsibility (OBR) watchdog released a report warning that our public finances are in a “relatively vulnerable position”.
The government is desperate to avoid a repeat of the fallout from September 2022’s ‘mini Budget’, and these recent episodes were innocuous by comparison. But keeping the bond market on side is easier said than done.
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Who will buy all this debt?
Reeves has bound herself by two “non-negotiable” fiscal rules, and the reaction to rumours of her departure suggests investors want a chancellor who is going to stick to them. These constraints are designed to “keep debt on a sustainable path while allowing much-needed investment to grow the economy”.
But even if the government sticks to its fiscal rules, it still needs to issue substantial amounts of debt. The Debt Management Office expects to borrow nearly £300bn this year, matching last year’s total, as the chart shows. But thanks to changing patterns of demand, the government cannot take investor appetite for granted.
Traditionally, defined-benefit (DB) pension schemes wanted long-term gilts in order to match their liabilities. In 1999, institutional investors (insurance companies and pension funds) held around two-thirds of all gilts outstanding, as the chart below shows. They were loyal customers, holding more than half of their total assets in UK government bonds. Today most DB schemes are closed to new members, and the defined-contribution (DC) schemes that replaced them favour more diversified portfolios, holding just 7 per cent in UK gilts on average.
With domestic demand shrinking, the UK government has turned to overseas investors, who now hold nearly a third of gilts. But attracting them comes at a price. The OBR warns that higher interest rates are needed to entice these new buyers, who, after all, have a wealth of alternatives. The watchdog calculates that interest rates on government debt could be forced to rise by 0.8 percentage points to compete for capital, assuming the stock of debt remains at 100 per cent of GDP.
Can the UK reduce its debt?
This is a colossal figure. Our debt-to-GDP ratio is the sixth-highest among advanced economies (after Japan, Greece, Italy, France and the US), and we face the highest borrowing costs of any advanced economy after New Zealand and Iceland. The government has pledged to address this with its fiscal rules (the second states that debt must fall as a share of GDP by 2029-30), but forecasts suggest that progress will be limited.
Projections from the OBR indicate that debt, by the broader public sector net financial liabilities (PSNFL) measure, will actually rise from 82 per cent of GDP to 83.5 per cent next year, before falling to 82.7 per cent in 2029-30. Under the old public sector net debt (PSND) measure, it will increase from 95.9 per cent to 96.1 per cent over the period. Rather than committing the government to slash debt, the rule is really a pretty loose constraint. The OBR says that it “broadly stabilises” debt by aiming for a modest fall in the final year of the forecast period.
And that is assuming that we meet the fiscal rules at all. The watchdog warns that “the scale and array of risks to the UK fiscal outlook remains daunting”, singling out pressure on defence spending and the healthcare and pension costs of an ageing population. Rather pointedly, the OBR notes that “planned tax rises have been reversed, and, more significantly, planned spending reductions have been abandoned”.
This points to a sobering conclusion: if the government isn’t meaningfully reducing debt, it must at least make sure that people want to hold it.
How can the government meet investor demand?
Between 2015 and 2019, only 6 per cent of gilts had maturities of five years or less, compared with around half for the US and Germany. By 2024, issuance of these shorter-dated gilts had risen to 30 per cent (see chart below) – more in line with other European economies.
Issuing short-dated gilts should help the government to tap into lower borrowing costs. The pivot could come at an opportune moment for investors, too. BlackRock analysts note that overseas reserve managers are currently looking to diversify away from US Treasuries and dollar assets, which could increase the pool of demand for shorter-dated gilts.
There could also be untapped potential in direct sales to UK retail investors. Elston Consulting estimates that annual demand for short-dated, low-coupon direct gilts is around £12bn, thanks to their tax advantages. With better awareness and platform access, it thinks the market could grow to £55bn-£80bn, allowing retail investors to step in as demand from pension schemes declines.
Why the economic backdrop matters
But issuance needs to be responsive. Economic conditions can quickly turn a good deal into a very bad one. Index-linked gilts (which still make up around a quarter of the UK’s debt stock) initially offered the government a ‘cheap’ way to borrow, but became a problem when inflation picked up.
UK government debt is so sensitive to changes in the price level that it would take just a 1 percentage point increase in retail price index (RPI) inflation to add £7.5bn to annual repayments this year. Analysts warn that short-maturity issuance could have its drawbacks, too, exposing the government to fluctuations in market sentiment as it returns more regularly to the market to refinance debt.
The Bank of England (BoE) also holds a significant chunk of UK debt (see second chart), but is winding down its holdings through quantitative tightening (QT). The BoE has pledged that QT should happen ‘gradually and predictably’, but has taken a more aggressive approach than its peers. While the Fed and the European Central Bank let bonds ‘passively’ roll off their balance sheet, the BoE ‘actively’ sells them, too, offloading a combined £100bn per year.
Since last September, the BoE has actively sold around £13bn of bonds. With fewer ‘passively’ maturing in 2026, the total is expected to rise to £52bn next year. The increase in supply could put pressure on gilt prices, pushing yields higher. Bank of America economist Sonali Punhani has questioned “whether QT is really operating in the background” in light of gilt price movements at the longer end of the curve. She expects the BoE to reduce QT to £60bn over the next 12 months, implying active sales of just £11bn.
Will the chancellor have more breathing space by the Autumn Budget?
This could indirectly influence the government’s finances. The BoE currently pays higher interest on bank reserves than it receives in coupons, and the Treasury covers the difference. A slower pace of gilt sales would increase this interest bill, but would also mean that fewer government bonds are sold at a loss. Bank of America’s Punhani thinks that the net impact on government finances of slower QT would be so limited that it probably equates to “a rounding error”.
But there could be broader consequences. QT is currently amplifying the effects of heavy gilt issuance, with increased supply weighing on prices and pushing up long-dated yields. A slower pace could reduce this pressure, lowering borrowing costs. These lower yields would, in turn, improve the chancellor’s headroom, and may help to calm market nerves as the Autumn Budget approaches. The BoE will set its QT target for the year ahead in September, potentially offering the Treasury some relief ahead of the next fiscal event.