Rishi Sunak’s burgeoning bill for borrowing via index-linked bonds is going to come back to bite chunks out of the Treasury again and again.
Brown’s blunder in 1999, selling more than half of the UK’s gold reserves at rock bottom prices, is an easy and obvious comparison to draw upon – and for some, a convenient opportunity for a bit of whataboutery.
On paper, Brown ‘lost’ the Treasury close to US$18bn, selling 401 tonnes of gold (about 14.14mln ounces) at a meagre average price of US$275 per ounce versus what those reserves would be worth today, about US$22bn with gold trading at around US$1,825.
Nothing will ever erase Brown’s woefully time gold sale from the City’s memory - because a) it’s easy to understand how a physical commodity deals work and b) well, it was Gordon Brown, wasn’t it.
Who is to blame for Britain’s soaring borrowing costs is much harder to pinpoint.
Nevertheless, the one silver lining to high inflation is supposed to be that it erodes the real burden of the national debt.
However, the UK’s borrowing costs are spiralling and are much worse than forecast.
The thing is, government bonds are supposed to be predictable and boring.
UK government bonds or ‘GILTs’ are in a practical sense guaranteed debt securities.
Once upon a time they were printed on paper marked with a gold coated edge, which as it happens is the origin of the sporting phrase ‘gilt-edged chance’, meaning an easy and unmissable opportunity. Ironic really, given that his political opponents will no doubt call out Sunak for the government’s expensive own goal.
A normal GILT would pay a fairly-tight margin of return over prevailing interest rates in the market.
Basically, GILTs traditionally provide investors with no risk but low reward.
Most GILTs are normally bought by pension funds as they provide long term security and ordinarily pay a just-about acceptable yield.
With minimal administration, the returns are boosted year-over-year as income from interest payments are reinvested, compounding as the years fold over on the calendar.
So, how then has the cost to the government spiralled so spectacularly that it’s increased by 70% from May 2021?
Blame inflation
Everyone it seems is blaming inflation for everything right now.
In this case though it is directly the rate of inflation, or more specifically RPI, that’s causing Rishi Sunak to delve deeper into his pockets.
If you want to cut the chancellor some slack (some will and some won’t) then you can sprinkle in some Covid-related excuses too.
Through years of quantitative easing and, more recently, government spending programmes through Covid - y’know for furloughs, billions spent on PPE-contracts and the other essentials like government subsidised Happy Meals at McDonalds – the Treasury issued more and more debt securities into the City.
There are more glamorous and exotic investments to sell than GILTs, particularly in a bull market as rampant as the one we recently witnessed.
QE was keeping the cost of money low, as the value of real estate was soaring, many stocks were going parabolic, meme trading became a phenomena and crypto-currencies like Bitcoin was exploding in value.
Meanwhile, as we’ve established GILTs are quite boring.
In order to sweeten the deal for investors, government’s increasingly offered bonds with indexation - which put simply means that the principal invested to buy the bonds was protected against inflation.
How it works
To protect the bondholder against inflation, the coupon (the amount paid by issuer to the bondholder) comprises an interest rate to be paid on-top of a benchmark measure of inflation (in the UK, RPI is the metric that’s used). At maturity, the bond redemption price is also adjusted for inflation.
For example, just seven months ago, in November 2021, the UK sold a new 50-year inflation-linked bond with a ‘record low yield’.
That index-linked bond matures in 2073 and pays a coupon of 0.125%, which essentially means it will pay an eighth of a penny on top of the rate of RPI (measured last month May at 11.7%) every year for just over fifty years. In 2073, the holder will then also receive an inflation adjustment to the original principal investment.
To illustrate the premium in the market price (otherwise known by bond traders as the ‘dirty price’) which is today pitched at £166 to £171, in other words, it will cost £1.71 to buy a £1 face-value bond.
Reuter’s November write-up of the bond issue noted that index-linked debt had ‘drawn greater demand in recent months’.
As inflation erodes the ‘real value’ of money it is easy to understand why demand for such a security was up, particularly for pension funds which need to park investment capital over the particular long term.
Of course, harking Brown’s gold trade, I’m sure that in 1999 there were buyers interested in picking up Britain’s gold at what turned out to be priced at a two-decade cyclical low.
How exposed is the UK?
At present, around £500bn of UK debt is index-linked representing a quarter of the UK’s £2 trillion sovereign debt pile.
Sky News, which was among the first to report Sunak’s indexation problem, in January highlighted that the UK’s borrowing costs were up around 200% compared with 2020.
Sunak’s interest payment for May amounted to £7.7bn, practically 50% more than the £5.1bn forecast by the OBR, and, the government increased borrowing by a further £14bn that month too.
It bodes ill for upcoming borrowing costs, given that the inflation adjustment applied to index-linked debt lags the most recent measure of RPI and there has yet to be any signal that inflation has peaked or is slowing.
Measured at an annual rate of 11.7% in May, RPI had risen at the fastest pace since the early 1980s.
Moreover, April’s borrowing data was revised up and the Chancellor is about to stump up for his recently announced supports for UK households.