Gilts – Losing their lustre?

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In the light of the unprecedented banking crisis, it is hardly surprising that UK gilt yields have remained quite low as investors have sought security in government-backed stocks. However, demand for gilts looks likely to change, a very worrying development given the Government’s horrendous borrowing requirement - £178 billion in this year alone. For 2010/11, a similar net borrowing figure has been projected.

To date, funding the Government’s borrowing has been surprisingly easy: much of this year’s enormous £225 billion gilt issuance programme has been undertaken successfully. The key to this success has been the Bank of England’s £200 billion Quantitative Easing programme, which seems sure to end shortly. Moreover, tighter capital rules have persuaded leading banks to buy more gilt-edged stock. Gilt yields, though, continue to fluctuate, with the 10-year 2019 benchmark stock currently yielding 4.1%.

With many major economies running formidable deficits, the UK may find it increasingly difficult to find buyers for its massive gilt-edged issuance. The recent decision of Pimco, the world’s leading bond house, to reduce its exposure to UK gilts and US government bonds is hardly reassuring.

If demand for gilts falls steeply, yields will rise. For 2010/11, the Government has projected a gross debt interest cost of almost £43 billion. This vast figure may prove to be an under-estimate. Indeed, if the outcome of this year’s General Election is a hung Parliament, the UK’s sovereign debt may be downgraded by the credit rating agencies – this would raise borrowing costs still further.

For the next Government, cutting the enormous public sector net borrowing deficit is paramount: substantial cuts in public expenditure are vital to achieve this aim. But political considerations are preventing the implementation of this policy – at least for the moment.

The current deficit is certainly unsustainable. But will the markets suddenly take fright and make it unfinanceable?