Gilt market risks | Insight Investment

In this section I'll be having a look at the the UK bond market.

As you can imagine from some of the comments that we've had earlier in the session, most of the questions I'm getting at the moment are people's worries about rising debt levels supply patterns, changes in demand. Indeed, one topic that surprised me a bit that has been a theme that's come up a couple of times in client meetings is whether the UK and the long end of the market will even be money good. and whether the fiscal concerns are that big.

So I thought it'd be quite good to have a look at these risks and see if things are maybe as bad as sometimes it sounds.

And the first place I like to start is always just thinking about what's in the price.

So if we have a look at this chart this just shows the long-term history of the 30 year swap spread. So that's the additional yield on gilts over and above swaps. And I think this is one of the best barometers of fiscal risk you can see 'cause it's like the credit spread effectively that the UK government is having to pay to finance its debts.

And to me, a few clear points stand out. The current spread, is sitting at the 77th percentile. So we are being paid much more than average to take on exposure.

Indeed, it's only the recent performance as this line comes down that's guilt outperforming. That's taken us away from the wide levels that we'd seen previously when pension schemes were sort of faced by the fact the insurance companies were selling their gilts and spreads went very wide in 2015 all the levels that we saw in the global financial crisis.

So fiscal risk is real but I'd make the, the statement that it is pretty fully priced.

Things are not really in the state where we were in the GFC.

Now, secondly, spreads have performed recently.

If we look at the period sort of post 2022 everybody was asking who's gonna buy all the Gils? the question that's been asked in the US treasury market now, but that was the question we were asking in the gilt market a few years back.

But actually now we've got the answer to that. We are seeing that the debt in the UK actually meets pretty strong demand now and that's why you see this line coming down because a new equilibrium has been found and guilts are actually having a bit of a day in the sun.

And the third point I'd make on this chart is just if we look back to the guilt crisis in 2022 things don't always move. As you might expect this metric here actually you see when the crisis hit, moves down the page that's guilt outperforming. And the reason for that is the Bank of England obviously stepped in to settle the market down. But my point there is the institutional framework behind the guilt market is very solid.

And that's why when I'm asked this question about what's the most appropriate hedging asset I think the gilts are critical for the UK government with no external non sterling debt. The guilt market is the sole source of funding for the uk That gives it some pretty unique characteristics.

So my first observation is that you are paid to own long guilds. The institutions of the UK will support them. So I'd actually make the contention that it's pretty expensive and risky to move away from guilds and look at other hedging assets.

So as we've seen here, we can see that gilts have been in demand and I said we've got an answer to that question of who will buy all the gilts. So who did buy all the gilts? we can break this down from the data from the Bank of England and you can see it's the top three groups really that have been increasing in terms of their market share. That's overseas investors, other financial institutions which is really hedge funds and retail investors.

MFIs, which is the banking sector.

You can see that the Bank of England share has gone down as they've been undertaking quantitative tightening and selling the gilts back that they've bought in via the A PF and QE and then also pensions and insurance whilst still very important. Clearly that sector is moving lower in terms of its overall holdings.

So there's been a pretty big change in the gilt market.

It used to be a sort of simpler challenge for me to stand up here and talk about what's going on in the guilt market when pensions and insurance really were the big story and we were in the middle of it.

But with 2022 that really marked the end of LDI dominance. And that was when these questions started of who's gonna buy all the gilts.

But before I move on from there was just one point about the Bank of England. When the Bank of England stepped in to settle the guilt market down in 2022 it only took 20 billion of intervention to actually pull that trick off.

Since peaking near 900 billion in 2021, the Bank of England's a PF has reduced by half to 450 billion.

I make that point just to say there's quite a lot of Bank of England balance sheet and operational capacity. If we were were ever to see a crisis that's not something they would use on the swap market. It is something that they would use on the bond market.

But anyway, we, we now have this different pattern of demand in the uk overseas investors take up 35 to 40% of syndication books. Banks are the most dominant buyer and other financial institutions as including hedge funds and retail now take down as well and are actually the largest part of market transactions.

in the guild market.

There's a lot written about hedge funds. but I would actually make the case that they're not such a negative influence in the gilt market and are now a vital part of the plumbing. And whilst they clearly bring, bring an element of risk and and I've mentioned them before, I do think that overall we need to be a little bit careful because if you remove hedge funds from the market the end result is gonna be a higher cost of funding for us all as taxpayers.

Now this change that we've seen with these new players coming in and being dominant, clearly there's a question of well what's the cost of that been? Have we had to pay up in order to meet or to attract those investors?

So what I wanted to do here was just look at the cost of issuance, that the DMO the debt management officer issues, the gilts, faces.

So these dots just show all of the different issuance points over time. So whenever a gilt was auctioned or syndicated, this is the yield that the money was borrowed at. And you can see how obviously, you know this follows the path of interest rates and we're now up as rates have gone higher.

Now if I add the other dots here this is looking at index think gilts, which are clearly a key part of the UK market. And what we have to do here is we have to do a little transformation because index think gilts have got a real yield. So you need to add an inflation assumption.

Now handily, the debt management office tells us what their assumption is and it's 2.9% for RPI when it is RPI. But then after RPI reform and we get CPIH, it's 2.4% and that's just one of the little minor point I wanted to just stop on there. A lot of people will assume the difference between CPI and CPIH is only 10 basis points.

The DMO and the OBR use a 40 basis point differential and I think that's something that not everybody has taken on board as yet.

And then what the DMO do next is just work out what the 12 month weighted issuances and then they can see the cost of debt overall over that period. And we can see here that it's 4.4% and that's actually not higher than the levels pre GFC. And indeed it's not moved a great deal over the last 12 months. So despite the fact that we've seen higher rates we're actually at levels in the UK that are not historically that unusual. So how has the DMO managed to sort of keep this or pull off this trick? What they've done is they've shortened duration of the issuance.

You can see here we've gone from issuing 20 year bonds on average down to sub 10 years.

So there's been a really, really big change in terms of the structure and the supply to the gilt market. But that's how they found the new buyers and that's what's managed to keep the market in equilibrium.

So the next question that we were asking is, well that's all well in good bit is this actually affordable for the government?

And if we look at the yield curve for both indexing gilts and conventional gilts, the rule of thumb that we use in the market is one and a half percent real yield, which is quite similar to the growth rate in the UK economy is probably an affordable level for debt. If the economy grows by 1.5%, you'll be able to pay that real yield back equally. If we then add the inflation assumption on in the UK of about 3% long term, you get to about 4.5% for the nominal market.

So really yields above that level are too expensive but yields below that level they can pay. That's why they're issuing in these sectors. The debt that they're issuing is actually affordable.

The long dated debt wouldn't be and that's why they've been pulling back from issuing as many long dated bonds.

So whilst this is in a particularly comfortable position there's not a lot of headroom on it at the moment. We are actually in a position where the guilt market has found this new equilibrium with which works for both the issuer and for the investor.

But the question that we then asked is well, can this continue?

Are there risks that are building up from the, the the perspective of the DMO in the debt stack that we have in the uk? Because clearly that's a big change that's happened and is it building up problems for the future?

Now the DMO quite handily have four different metrics that they look at in order to try and assess and answer that question. And therefore it was a relatively simple job for us to build a dashboard which then looks at these different metrics to see where we stand.

And the first thing that we look at is refinancing risk. The refinancing risk is simply how much of this debt rolls off over a one year or a five year period.

And the thing to take away here I could realize the chart might be difficult to read from that distance, is just that these lines haven't moved. They've been very stable really since sort of going back to sort of 2004.

And that's actually something that with this switch that they've done with issuance, quite surprised us and actually shows that the debt book is in reasonable shape.

The next thing they look at is something called re-fixing risk. And this is just thinking about the debt that can actually change in cost over a one in a five year period. So effectively that takes into account any debt that matures, but then you have to add onto it things like floating rate notes or alternatively, sorry additionally index link gilts because clearly index link gilts can change as inflation changes.

But again, when we look at this metric we're not seeing these lines move sharply up the page which would be worrying us. They're actually very stable.

And this means that the DMO can continue to issue in this pattern for the foreseeable future. It's not building problems up for them.

I think the one thing that they are concerned about is the amount of inflation risk in the book. They've explicitly said this before, they've been reducing the amount of linkers. Clearly that fits as well 'cause there's not the same pension scheme demand out there but this is one area I really do think that there they'll be throttling back on. They did in the most recent, remit update. And indeed this plays into our positioning for our discretionary accounts. But overall, when we look at the overall weighted average maturity of the, debt in the uk you can see whilst it's come down at 14 years it's longer than most countries.

And actually it's longer than it was when you could wind the clock back to, the the start of the turn of the century.

So actually we were really pleasantly surprised looking at all of this to say how well the UK looks in terms of its debt issuance.

And that means that the ZMO, when they think about what to do next, They actually have the opportunity to continue to shorten their weighted average maturity. Indeed there's been the consultation with T-bills which has got a very positive response, which we'll see that sector of the market emphasized even more.

I think if they do see lower yields then they'll start issuing long-dated debt but they're not under any pressure to do that.

So overall, we actually took quite a lot of comfort from this indeed. If we then switch to looking at economic fundamentals we also can take some comfort here. If we look at the primary balance, IE the deficit that the the government is running you can see there the uk whilst it has run significant deficits, that's been improving and compared to global peers actually the UK's at the top of the pack.

Now then on the right hand side I think I got a little bit carried away here because that red line isn't the uk, that's Germany.

We are the, we are the line above it but actually we are just that one line above it. And you can see there that the UK is not expected to see government debt as a percentage of GDP rising dramatically as the lines above it which are France and the US are.

So all in all, I'm just trying to sort of push back a little bit on the pessimism. One can feel about the guilt market at the moment. To me it looks attractively priced. There's plenty of investors buying the debt the supply pattern can continue and the fiscal numbers don't look quite as bad as they do when you go abroad.

The thing is, is obviously there is a reason that we are priced at the 77th percentile and that's because can you trust these forecasts? Because clearly they're based on something and that's politics. And this really is the big risk factor that everybody's trying to weigh up. When you look at the right hand chart there, you can see how the labor vote has absolutely collapsed or expectations of it have absolutely collapsed. And we saw that in the most recent by-election and that has been picked up by both reform and the greens. And whilst I'm not gonna have, or try and make out that I've got any confidence in what a general election could be predicted to look like now when I look at the left hand table and I see the splits of expected seats between different parties, the one takeaway I have is I dunno what fiscal policy is gonna look like after the next election, in August 29.

And that's the one thing that we are then having to wrestle with and it's a few years away but clearly the market is gonna be looking at the local elections very closely to see exactly where it thinks that general election will come out.

So in summary, despite some of the, the the questions that I've been asked about fiscal risk in the uk, to me, gilts remain the hedging asset of choice. They're institutionally critical.

The fiscal risks that are out there are undeniable but the UK's not the worst. and the debt that the UK is issuing is in equilibrium and is affordable politics. Well, there's been plenty talked about that we can't really tell and that is the biggest risk. But my advice would be that if you are really concerned about the fiscal risk in the uk, probably the best thing to do is to hold assets outside of Sterling. That'll be the way that it will that you'll be rewarded if there was a fiscal problem in the uk rather than reshaping your hedge away from guilds.