The UK was an early and eager adopter of inflation-linked bonds. It used to boast that tying debt interest payments to the retail price index (RPI) underlined its inflation-busting credentials. The policy has not aged well.
“Linkers” account for a quarter of the UK’s debt. Rampant inflation is set to push this year’s interest costs to the highest levels in the developed world.
Debt interest will be a tenth of government spending — or £110bn — in 2023, according to Fitch. The UK will have to sell more bonds to cover the deficit. The Debt Management Office expects to issue a near record £241bn worth of gilts in the coming financial year.
What is the impact of selling so much debt for investors? Curiously, it may make little difference.
Some domestic investors have regained a taste for gilts after last year’s rout. Bank of England governor Andrew Bailey has restated his commitment to bringing down inflation. The UK’s largest asset manager Legal & General recently said it was buying bonds. It expects fixed income to benefit from a renewed appetite for safety.
The main driver of bond yields has historically been interest rate expectations rather than supply. Forecasts drove the vast majority of the 300 bps increase in 10-year gilt yields since February 2022, according to BoE analysis. That suggests that the end of quantitative easing has had little effect on yields.
Yet some nervousness is justified. Many corporates are transferring defined benefit pension schemes, historically a big driver of bonds demand, to insurers. These typically invest in a wider range of assets. Private foreign investors already hold more of UK debt — 25 per cent — than most other G7 countries.
Higher interest rates are feeding through to debt servicing costs more than twice as rapidly as in the past. In 1981, the last time the RPI was in double figures, the UK had only just started to issue index-linked gilts.
Historically, inflation helped governments lighten their debt burden. This time it is having the opposite effect. That underlines the incentive to vanquish it — a vindication of sorts for advocates of linkers.
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Source: Economy - ft.com
