When linkers bite back

21 October 2022/No Comments
By Nick Dunbar

As inflation becomes more persistent across developed nations, inflation-linked debt becomes particularly costly for governments, even as nominal borrowing costs rise. A dramatic example of this can be seen with the UK, which pioneered this form of borrowing in the 1980s, and is struggling to restore fiscal credibility after its abortive mini-budget in September.

The UK’s Office of National Statistics flagged the rising cost of linkers back in May, noting that index-linked gilts accounted for £40 billion of the UK’s £75 billion annual interest payment bill – an outsized contribution considering that linkers are 25% of outstanding gilts. Meanwhile the US is set to pay $150 billion in interest this year on its portfolio of Treasury Inflation-Protected Securities (TIPS), half the interest bill on nominal treasury bonds, according to the US Treasury website. This is even more remarkable, given that just 9% of US government bonds are TIPS.

These costs are set to rise further, based on market inflation expectations. Using a new visualisation tool created for this purpose, we estimate that for the £2 trillion of UK gilts, annual interest costs are set to rise to £110 billion per year in 2024, and stay at around £100 billion annually for a decade. That’s double UK government forecasts, and doesn’t take into account any additional borrowing.

Date of 10y benchmark yield used for refinancing Sep 2022 Current
This visualisation shows future government debt interest payments of the UK. Use the buttons at the top to change the valuation date. The red bars show interest payments on existing nominal gilts. The blue bars show the cost of refinancing maturing gilts at current market rates. The yellow bars show the interest cost of inflation-linked gilts, using ONS methodology for annual principal uplift.
Data source: Markit iBoxx

With the UK government about to make difficult decisions about spending and taxation, debt interest becomes more important since in contributes to deficits. Why are inflation-linked bonds proving so expensive?

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