Benstead on Bonds: what the Budget will mean for gilts

The Budget on 30 October could be the most significant since the beginning of George Osborne’s austerity drive in 2010.

Labour Chancellor Rachel Reeves has identified a £22 billion “black hole” in the country’s finances that needs to be plugged with tax rises or spending cuts.

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But the new government has pledged not to raise the three main taxes: income tax, national insurance tax and VAT.

This means that it needs to get creative to raise the money, and experts expect changes to pensions, inheritance tax and capital gains tax.

These may include cuts to the tax-free lump sum from your pension, increasing capital gains tax to align it with income tax, or the inclusion of AIM shares as part of your estate for inheritance tax purposes.

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Bond markets were calm following the summer election due to signals that the Labour government was going to be fiscally responsible, but there are doubts appearing among investors that the new government will loosen its purse strings.

When investors are worried about the financial position of a government, they sell the national debt, which pushes up bond yields. These higher yields indicate investors are demanding a greater return from their cash, which may be to compensate them for higher inflation, a weaker currency, or an increased chance of default. Higher yields mean the government is paying more to issue debt, something that it is of course keen to avoid.

Finance ministers must therefore tread the line carefully of reassuring bond markets, while also accommodating the prime minister’s spending plans.

Why have gilt yields risen?

When Labour took office in July, the 10-year gilt paid investors around 4.2%. As inflation continued to drop and the Bank of England made its first interest rate cut, confidence was high that the UK economy was in a good place, supported by a fiscally responsible government. Yields went lower, reaching 3.8% in the middle of September.

But now sentiment has turned and gilt yields have increased to a similar level to when Labour took office.

Ben Lord, who manages the M&G Strategic Corporate Bond GBP A Acc (3382813) fund, said he was worried about political risk around the coming Budget, including fiscal rules being changed and the increased issuance of gilts.

“There are risks to gilts. I’m worried about the fiscal rules being changed, I’m worried the issuance of gilts goes up, I’m worried there might be an adverse bond market reaction.’” he said, as reported by news site Citywire.

Not all gilts are affected equally by this market shift. Most ii customers use gilts as a savings tool by holding short-term bonds to maturity, such as UNITED KINGDOM 0.25 31/01/2025 (LSE:TN25)and UNITED KINGDOM 0.125 30/01/2026 (LSE:T26), which mature in January 2025 and 2026.

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These “ultra-short” bonds have a low “duration”, or sensitivity to interest rates, and generally do not experience big prices swings – rather, prices gradually tick towards the £100 redemption value as the bonds near maturity.

The same is not true of longer-dated bonds however, with the likes of TG61, maturing in a little under 40 years, experiencing considerable volatility. UNITED KINGDOM 0.5 22/10/2061 (LSE:TG61) dropped from £32 to £29.50 over the past month.

Meanwhile, 4¼% Treasury Stock 2036 (LSE:T4Q), which matures in March 2036, saw its price drop from £103 to £99 over the past month.

Gilt funds have also been affected, as well as bond funds that invest in corporate bonds.

Possible changes to fiscal rules are on investors’ minds. The government has specific rules in place which contain how much they can borrow relative to GDP.  They use these to keep spending in check and communicate to markets that they are fiscally responsible, although there is nothing stopping them from breaking or altering the rules.

There has been speculation that Rachel Reeves may alter the definition of “debt” to give herself move room to spend. For example, she could take debt used for capital investment, for schools or roads for example, out of the equation on grounds that this type of investment is essential to stimulate growth. Money raised for Labour projects like GB Energy and the National Wealth Fund could also be excluded from debt calculations, according to reports.

Deutsche Bank expects a “flexible and modestly looser fiscal framework” to be announced on 30 October.

“In pushing for a current budget balance, the chancellor can focus her tax raising efforts solely on day-to-day activities, whilst also giving herself some space to adjust to a slightly looser Spending Review than the one pencilled in by the previous government.

“A subtle but important adjustment to the debt rule also allows the Chancellor some flexibility in driving up investment, whilst also reducing the impact of the Bank of England's quantitative tightening decisions on fiscal policy,” Deutsche Bank said.

Should you buy gilts?

More spending could therefore justify investor concerns about the UK government, and lead to higher gilt yields (and lower gilt prices).

But that could be just short-term thinking. Jon Mawby, Co-Head Absolute and Total Return Credit at Pictet Asset Management, sees any rise in gilt yields as a buying opportunity. He believes that the trend in bond markets will be for lower yields and higher bond prices, as governments need low borrowing costs to fund their deficits. He thinks the UK economy is weakening, which will help the Bank of England lower interest rates without worrying about a rebound in inflation.

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Mawby adds: “The UK economy is weakening by the day and we are going to see a budget that makes that worse. Plus, you have a debt-based economy that relies on the ability of people to borrow – therefore only way that this government funds what they want to do is with lower gilt rates.”

His view is that because a recession is likely, investors should own high quality, high duration assets – those that are having long maturity dates and are therefore more sensitive to interest rate changes.

He even says that yields could go below 1% globally, as governments don’t have a choice but to drive down the cost of borrowing given the size of their deficits.

The rise in gilt yields in the run up to the Budget also has to be put in the context of rising bond yields globally, not just in the UK.

While 10-year gilt yields have jumped to 4.2%, from 3.8% a month ago, 10-year US government bonds have risen a similar amount, from 3.7% to 4%.

Global bond market movements therefore show that the UK is not an outlier, despite having an important fiscal event in two weeks’ time.

There will undoubtedly be a lot of noise in the run up to the Budget, which will cause volatility in gilt prices, but the general outlook for bonds looks positive: inflation is back around central bank targets, interest rate cuts have begun, and bonds have shown a negative correlation with equities recently in times of panic.