L&G explains: Demystifying the gilt market

Barely a day goes by without a headline worrying about the state of the UK public finances. However, the debate on public debt is often quite abstract and filled with obscure acronyms (PSNFL* and PSNCR** are particular favourites). In this blog, I try to explain the broad contours of the gilt market (and its influence) in accessible terms.

How big is government debt?

Imagine a pile of £20 notes. Make that pile 1.75 metres tall. That’s roughly the height of an average man in the UK. You now have £350,000. Next imagine a pile equivalent to ten men standing on top of one another. Congratulations. You now have a 17.5 metre-high pile worth £3,500,000. That’s the height of a five-storey building. 

Now go a bit further and picture that pile duplicated until you have filled every square centimetre of the pitch at Wembley stadium (105m x 68m). Now you have an amount of money approximately equal to the size of the national debt: £2.8 trillion. Viewed another way, it is a little more than £40,000 for every man, woman and child in the UK. It's a huge amount.

That borrowing takes several forms. Premium bonds are a form of government borrowing owned by more than 24 million people. But premium bonds and other National Savings and Investment (NS&I) products are a less than 10% of the total debt. The vast majority is in the form of IOUs issued by the government. These are gilts (or, gilt-edged securities).

The government’s ‘mortgage’

You can think of the gilt market as being like the government's mortgage. But whereas a household's mortgage typically has a single fixed term, the gilt market is made up of many individual mortgages with maturity dates ranging from 2025 all the way out to 2073. 

Another key distinction is that while your mortgage is secured against your house. In the unfortunate event of your failing to make mortgage repayments, the lender can start repossession. Gilts are not secured against anything other than the government’s promise to repay. Those promises have never been broken since the market started in 1694, but the lack of intrinsic security underlines the importance of government credibility to maintain confidence.

The secondary market

Also, unlike most mortgages, there is an active secondary market in gilts. IOUs sold to one investor are frequently sold on to other investors. The price at which those transactions happen determines the gilt yields quoted in the financial press and, on dramatic days, the front pages. Daily turnover in the gilt market is around £40bn with 10% of the market bought and sold every single week. 

Why does the price/yield on gilts move?

There are two broad reasons why the yield on gilts moves. 

The first is the one that grabs the headlines: changing perceptions of the government’s creditworthiness. But for government’s borrowing in their own currency, this is rarely the most important determinant of yields. The government can levy taxes and, in extreme circumstances, instruct the Bank of England (BoE) to buy their debt. The market-implied probability of government default is minuscule, but when it is brought into question the market impact can be sudden and dramatic.

Instead, changing perceptions of monetary policy and the outlook for overnight interest rates are what typically matter. The BoE sets the overnight risk-free rate for the whole system. Investors assess the attractiveness of the gilt market relative to their expectations for that risk-free rate. If the market expects higher overnight rates due to either economic news, or hints from monetary policymakers, gilt yields rise in concert. 

The primary market

The secondary market operates alongside a primary market in which gilts are sold by the government to cover any additional borrowing they need to make (aka the deficit) or because previously issued gilts have come due and the principal needs to be repaid to lenders. 

Taken together, the deficit and maturing debt make up the government's gross financing need. It is that gross financing need (around £250bn) that makes government finances sensitive to changes in market interest rates. 

Real-world context

The impact of a 1% increase in interest rates snowballs over time. The government must spend an additional £2.5bn in year one due to the interest rate increase, but around £12.5bn in year five as more and more debt refinances (or rolls) at higher rates. To put those numbers in context, the total police budget in England and Wales is £17bn.

Are gilts ‘productive assets’?

It is sometimes implied that when institutional investors hold gilts, they are holding back the UK economy by failing to invest in more productive assets. That is a strange argument. Gilts finance public sector infrastructure: they are only ‘unproductive assets’ if the same is true of the investments which they finance. If roads, schools and hospitals are productive assets, then the same is true of government bonds.

Who owns gilts?

Some people own gilts directly, and they can be very tax efficient savings. But most people don’t. Less than 1% of the gilt market is owned directly by households. Instead, households own gilts through an intermediary such as a pension fund, bank or insurance company.

If you have a corporate DB pension, the pension fund will almost certainly be partially invested in gilts. If you have life or house insurance, the insurance company will almost certainly be partially invested in gilts to help fund future payouts. If you have a bank account, the bank will almost certainly be partially invested in gilts as a high-quality liquid asset. All three are intermediating between your preferred savings vehicle and the government’s desire to borrow.

The gilt market also competes with other government bond markets around the world. UK investors buy overseas bonds, and overseas investors buy UK bonds. That link makes gilt yields heavily influenced by what’s happening elsewhere, in particular, in the $36 trillion US treasury market. You need to imagine a dozen Wembley stadiums filled with cash to get a handle on the size of total US public debt.

Why should you care about the gilt market?

The total net primary market capital issuance of equity and debt for the UK corporate sector has averaged £33bn per annum over the last five years. In the gilt market, net issuance has averaged over £150bn per annum. 

The government needs to borrow to cover the difference between what it raises in income (tax revenue) and what it has in terms of ongoings (think expenditure on education, healthcare, welfare, pensions, defense, infrastructure etc.) So the gilt market has plenty of ‘real-world’ importance.

Government bonds form the backbone of the pricing of almost all other financial assets. If I can lend to the government (with the ability to levy taxes) at 5%, I am not going to lend to anyone else at a lower rate. When the yield on gilts rise, it therefore impacts anyone wanting to borrow in the sterling markets. This is most obvious in the sterling corporate bond market, but the borrowing costs of banks, big corporations, and households are all dependent on gilt market pricing. Less directly, equity and property returns are typically modelled as a risk premium over and above government bond returns.

When it comes to total debt and equity raising in the UK, or to understanding the price of sterling assets, the gilt market is the elephant in the room. 

To discover more about our latest thoughts on the UK gilt market, please listen to our CIO, Sonja Laud, who spoke recently on BBC Radio 4.

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*PSNFL: Public Sector Net Financial Liabilities. It is the government’s new measure of net debt which take account of financial assets (as well as liabilities) across the while public sector.

**PSNCR: Public Sector Net Cash Requirement. It is a measure of the total cash needs of the public sector. This is the shortfall of revenue relative to expenditure that needs to be financed.