Toby Nangle, Director, Multi-Asset and Fixed Income Team at Baring Asset Management, unravels the funding implications of the UK’s latest Budget.
The UK government funding requirement for 2009/10 was forecast in today’s Budget to be GBP167 billion, a substantial rise from GBP25 billion in 2009/10.
Historically, the Treasury has been reluctant to make use of Inflation-Linked (IL) Gilts, preferring to issue the great majority of its debt in fixed-rate instruments. Should this change?
The argument for moving the greater part of the present funding to Inflation-Linked appears compelling. Since the introduction of FRS17 linked pension fund liabilities directly to company balance sheets, there has been an enormous pool of unsatisfied demand for IL Gilts. The advantage to a company with a defined benefit pension scheme (even one that is closed) is that IL Gilts provide a closer match between a fund’s assets and its liabilities from an accountancy perspective. The alternative, for example where the fund is invested predominantly in equities, is a constant need to manage surpluses and, much worse, deficits as asset prices move in different directions to (an accountant’s) estimated value of pension liabilities.
It could be argued that it is the Treasury’s job to fund the government in the cheapest way possible, rather than concern itself with providing assets convenient to pension schemes. However, in the current environment, the cheapest funding source that the government has is IL Gilts. At present, the 2055 fixed rate Gilt yields 4.45%, while the 2055 IL Gilt yields 0.55%.This gap – often called the ‘inflation breakeven rate’—of 3.9% is extremely large, and should inflation come in on average in line with the Bank of England’s 2% target, there are substantial costs associated with issuing fixed-term instead of IL bonds.
Taking current market rates and the IL issuance projected in the Budget, the cost to the Treasury of issuing fixed-rate Gilts in preference to Inflation-Linked, for the upcoming 2010/11 funding requirement, would be in the region of GBP2.7 billion in every year until redemption. Over the next 15 years that is a total premium – or one year’s funding – of GBP40.5 billion. At such a rate, it would not take long for public liabilities to be hundreds of billions of pounds in excess of what they needed to be.
At a time when all political parties are eager to show off their deficit-cutting determination, how could the Treasury justify paying such a vast premium? Three reasons come to mind.
One is that pension funds switching into IL Gilts would mean selling off their current assets, predominantly equities. It might be, given the turmoil of recent years, that the Treasury fears destabilising the equity market and undermining an important indicator of economic confidence.
A second reason might be that the Treasury—or the government—simply does not believe that inflation will remain within the range suggested by the current Bank of England target. Instead, it thinks inflation will be much higher and that, as a result, fixed-rate Gilts will prove considerably cheaper. It would not be for us to speculate whether there might be a political intention to raise the target for the very purpose of ‘inflating away’ the government debt.
A third reason could be that, within the Treasury, expectations of government funding requirements are much higher than the Gilts market currently believes. In this case, it would be important to keep pension funds, which are practically forced buyers, hungry for government debt.