Why are investors apprehensive about the gilt market?

The writer, a former global head of asset allocation at a fund manager, delves into the concept of bond vigilantes and their impact on the UK government bond market.

For centuries, governments have been influenced by bond markets. However, the term “bond vigilante” was coined just 40 years ago by economist and Wall Street analyst Ed Yardeni. He argued that if policymakers failed to regulate the US economy, bond investors would step in.

Last September, UK government bond investors responded with panic rather than stepping in. The outcome of this panic was the reversal of heterodox policy measures and the resignation of Liz Truss as prime minister, both of which were seen as appeasements to bond vigilantism.

This week, UK government bond yields have crossed the levels that caused last year’s financial turmoil. However, there has been a noticeable absence of market panic. Fund managers are now eagerly declaring gilts as attractive, and defined benefit pension schemes are experiencing record surpluses, not requiring intervention from the Bank of England to save them.

So, what has changed? Today, higher bond yields are seen as a feature of policy rather than a bug. In contrast, last year’s collapse was the result of then Chancellor Kwasi Kwarteng’s move towards policy heterodoxy, inadvertently triggering a set of leveraged positions that caused a “run dynamic” in the gilt market.

Regardless of how they are arrived at, higher yields come at a cost. This has implications for over 400,000 UK mortgage holders who will need to refinance their fixed-term mortgages this year. Those with rates below 2.5% will face varying degrees of financial burden, ranging from expensive to potentially ruinous.

The government also faces costs. As the issuer of its own currency, the UK government operates under fiscal rules to manage public finances and mitigate the risk of default or inflation. These rules include reducing public sector net debt and balancing the budget within a five-year timeframe.

Despite the rise in bond yields, meeting the debt target in the short run shouldn’t pose a challenge. Only a portion of government debt is inflation-linked, while government revenue and gross domestic product are predominantly inflation-dependent. This implies that debt is being eroded by inflation.

Furthermore, interest costs as a percentage of GDP remain low, despite the high debt stock. This is partly due to locking in a significant amount of long-term debt at low yields, which puts the UK government in a favorable position.

It is worth noting that typically, government debt interest costs need to reach around 5% of GDP before causing serious concerns for finance ministries. In such cases, fiscal adjustment programs tend to follow. While the UK is still some way off from these levels, an extended period of elevated yields will increase the debt service cost pressure on the broader budget.

The gilt market carries increasing importance in our lives. Ignoring its impact, as demonstrated by Liz Truss, can be costly. However, it is also essential to strike a balance and not overly cater to the bondholder lobby, as their financial interests thrive in the absence of economic growth and disinflation. Fears of bond market turmoil should not delay crucial investments in vital infrastructure or the green transition.