Until a couple of weeks ago most people outside the financial world hadn’t heard of gilts. So, what are gilts?
In some ways, this was a good thing. Gilts are used by the government to raise money from investors to fill the gap between revenue (taxes) and spending.
They are far more important to the financial system than any other asset.
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The interest rates on gilts set prices for things like mortgages, financial derivatives and can dictate government spending plans. They are essentially the foundations of the country’s financial system.
That’s why the chaos of the past few weeks has had such a huge impact on the UK economy.
What is a gilt?
In the simplest possible terms, a gilt is a loan from investors to the government. When the government is spending more on services than it is collecting and tax revenue, it needs to make up the difference.
When I need to borrow money to cover expenses, I can turn to the bank for a loan or use a credit card. If I want to borrow £1,000, the bank will look at my finances and credit score and make me an offer based on its risk calculations. If I have a poor credit score, the lender might demand a higher interest rate, say 15% per annum to borrow £1,000. If I have a better credit rating, I might be able to get a lower interest rate than the average borrower.
The government borrows money using bonds called gilts, which earned this name as they originally had gilded edges.
Bonds and loans are very similar. The government issues bonds via the Debt Management Office (DMO), which is responsible for managing gilt supply and demand and deciding what sort of gilt to issue.
Gilts have a fixed life (the average life of a gilt is 14 years) and pay a “coupon” rather than interest to investors. At the end of its life, the full face value of the bond is repaid. This is called the “principal.”
The coupon is set as a fixed percentage of the gilt’s issue price and is usually paid annually or semi-annually.
When the government's coffers need topping up, the DMO reaches out to a select group of financial institutions. These banks take the pulse of the market to try and establish how much the government will have to pay investors for them to buy the gilts.
The coupon rate (or interest rate) is determined by various factors, such as the price of other bonds in the market and the base rate of interest set by the Bank of England.
How UK gilts work
Most government bonds are issued at a price of £100 and the coupon rate is based on this number. For example, if the market says the government needs to pay 1% to borrow money, the coupon on a gilt will be set at £1 to be paid twice a year in instalments of 50p.
However, gilts are a widely traded asset and as such, their value can rise and fall. If investors like what they see, they might start buying. But if they are worried about the country’s financial prospects, they may decide to sell.
This is precisely what happened after Kwasi Kwarteng’s mini-budget. The former chancellor’s plans to slash taxes and borrow tens of billions of pounds more every year to fill the gap spooked gilt investors and they started selling. And as the price of these assets fell, yields increased.
Returning to the example above, if the gilt issued at £100 with an interest rate of 1% fell in value to £90, the yield would increase to 1.1%.
This is where it gets a bit complex. The gilt yield and coupon rate are not the same. The yield takes the gilt price into account as well as the coupon rate and can change based on market prices. The coupon rate is fixed for the life of the bond.
While an increase from 1% to 1.1% might not seem like much, it is a 10% increase in the cost of borrowing.
The UK has over £2 trillion of gilts outstanding. While many of these have fixed interest rates over several decades, it’s easy to see how a 10% increase in borrowing can have a huge impact on the country’s financial position.
Borrowing costs could rise further due to gilt turbulence
Gilt prices have slumped (and yields have jumped) as investors have recalibrated their views on the UK economy and the actions the Bank of England might take to try and cool inflation in the months ahead.
The government, like all borrowers, will have to pay more interest to borrow money if the Bank of England pushes interest rates higher.
This could have huge implications for the economy.
We’re already seeing how higher gilt rates mean higher mortgage costs. When banks loan money to homebuyers they tend to hedge their exposure with derivatives known as swaps. These are priced based on gilt interest rates. Rising rates on gilts have sent mortgage rates skyrocketing with the average two-year deal now sitting above 6%.
Unfortunately, it looks as if this is the new normal.
According to analysts at Deutsche Bank, gilt yields have averaged 4.5% since 1700. We’ve been spoilt by ultra-low interest rates really since the turn of the century.
Still, the scale of the adjustment has been unprecedented. It took 12 years for yields to fall from around 4.5% in mid-2008 to an all-time low of around 0.1% in August 2020. It has taken a little over two years for yields to return to the long-run average.
The bad news is, it looks as if higher gilt yields are here to stay (if the long-term average is anything to go by). That means higher mortgage costs, higher loan costs and some tough choices for the government.
Is there any good news?
There is a silver lining in all of this. Higher interest rates are great news for savers. Interest rates on savings accounts are now as high as 5%. We’ve not seen those sorts of returns for years.
At the same time, annuity rates have also jumped. Annuity rates are based on government bond yields and have benefitted from surging gilt yields. Rates on these retirement products have increased by nearly 15% in the past month.
And then there’s pension funds. While there’s been a lot of attention about the risks to pensions about falling gilt prices over the past few weeks, funds are also set to benefit.
Higher gilt yields mean funds earn a better return on their gilt holdings, which makes it easier to fund future liabilities. Early estimates suggest pension funds could be up to £500bn better off thanks to recent market movements.
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