On the go: A rebalancing by the government from fixed interest to index-linked gilts could provide additional security for pension schemes and their members while saving taxpayers billions, according to analysis by LCP partner Jonathan Camfield.
In last Wednesday’s budget, chancellor Rishi Sunak announced yet another round of borrowing to finance the government’s ongoing pandemic response, taking the total to £450bn and raising the national debt to £2tn.
The bulk of this borrowing is financed by the issuing of gilts, specifically fixed rate gilts, which will make up 90 per cent of next year’s £330bn issuance.
However, in analysis published on Monday, Camfield argued that the interest rate on these fixed rate gilts is significantly higher than that on index-linked gilts, which make up the remaining 10 per cent of gilts issued.
While the 20-year interest rate on fixed rate gilts is 1.4 per cent a year, the 20-year rate for index-linked gilts is minus 2.1 per cent a year plus inflation.
“Even if the inflation rate turned out to be 2.5 per cent, this would still mean the taxpayer forking out 1 per cent less a year than on a fixed rate gilt. Given the size and duration of government borrowing, such differences, repeated year after year, could make a real difference,” Camfield said.
Tilting the balance toward index-linked gilts would have beneficial implications for UK pension funds, he continued, especially those that pay out inflation-linked promises to their members.
The great demand by defined benefit pension schemes in particular would assist the government in keeping the cost of borrowing affordable, while the demand itself would probably prove more durable than the one for fixed rate gilts, he argued.
“The demand for [fixed rate] gilts has been reasonably strong to date, meaning that the taxpayer gets a good deal — this is because the high demand means the government only needs to pay relatively low rates of interest,” Camfield explained.
“This high demand has, of course, been propped up by the Bank of England buying many of these gilts through its quantitative easing programme, but many question how sustainable this is. And in the past month the market prices of these gilts has fallen, perhaps because of an expectation of a flooding of the market.
"This means the taxpayer will have to pay higher rates of interest when issuing new debt in the future. And it seems to me that there is an increasing risk that this interest rate goes up further as the pandemic unwinds — costing us all more money.”
By contrast, the 10 per cent of gilts issued that are index-linked represent only a fraction of the number schemes need, Camfield added. The high demand keeps the cost of buying index-linked gilts “very high indeed, and there are not enough to go around”.
He suggested that the demand for fixed rate gilts from other investors, such as overseas investors, is more fragile because these investors “can also switch to other non-sterling debt”.
