The battle of the bond markets and public finances

Bond and equity investors are fundamentally in opposition. A bondholder cares only about receiving their interest and capital; anything that puts that in danger is bad. The ideal borrower might be one that takes your cash, parks it in ultra-safe assets to protect the principal and makes paying the coupons the only priority for its cash flow. There is no upside if the borrower takes risks. In fact, there is not even much value in long-term survival: the borrower can fail due to a lack of investment and the bondholder is still happy if they have been repaid in full.

On the other hand, equity – “the fine sliver of hope between assets and liabilities”, as Russell Napier calls it – hopes to profit from growth in earnings or assets. Shareholders want the company to take some kind of risk because they benefit if that risk pays off. If that might increase the chance that loans aren’t repaid, so be it.

This is well understood by markets. Nobody expects bondholders and shareholders to speak in each others’ interests. Yet when it comes to the public finances, that gets completely lost.

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All about the bonds

Today, we hear endless talk about why the chancellor needs to cut spending, raise taxes or both. Look at this through the bond-equity framework, and we can see that this is framed in bondholders’ terms: it’s all about making them feel more secure. The discussion rarely touches on whether borrowing is rising because of current expenditure or long-term investment.

Bond investors could make a very valuable intervention by signalling that borrowing to invest in the infrastructure that Britain needs (with a well-costed plan) would be seen very differently from borrowing to fund profligate current expenditure. Yet most talking points simply boil down to “large deficit = bad”.

This reasoning gets stretched into some bizarre pretzel logic. Raising taxes will slow growth since disposable income will be reduced, we are told approvingly. That may curb inflation and allow interest rates to be lowered, which is good for bonds. Yet the idea that anybody else would want weaker growth in an economy that is clearly not overheating is frankly unhinged.

Equity holders in this scenario are everybody who benefits from a stronger economy and more investment. And this is where long-term consequences of the current mindset look so worrying. Consider the visible deterioration in physical and social infrastructure in Britain. Failure to fix this because the government is cowed by the self-important bond vigilantes will open the door further to populist parties.

At present, UK 10-year gilts yield 4.4%. This is not high by past standards: it only feels high because of 15 years of ultra-low rate policy. True, it is high enough that rising interest costs puts even more strain on public finances, which makes the challenge even greater. But what compensation does it offer for, say, the inflationary risk of a future government in five years’ time with a populist mandate to spend and willingness to be radical? Very little.

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