UK Debt Binge Could Haunt Its Bond Market for Years

As investors begin to come to terms with the UK government's borrowing needs over the next few years, they are starting to realize just how large they are. And it doesn't look good.

According to estimates from banks, net gilt supply is likely to reach an all-time high in the next fiscal year. This means that, in order to absorb all the new gilts, the market will need to find twice as much private cash as it has over the last eight years combined.

The UK's gross financing projection is expected to increase by almost 50% to £1 trillion ($1.2 trillion) over the next four fiscal years, according to the Debt Management Office. This is a significant deterioration of the medium-term picture, according to Barclays Plc.

While the market initially cheered Chancellor of the Exchequer Jeremy Hunt’s package of tax increases and spending cuts Thursday, the reality is that a staggering amount of bonds coming online may pressure the market. Concerns are already starting to mount over the challenge of finding buyers, particularly given the Bank of England is now shrinking, rather than expanding its holdings. This could lead to higher borrowing costs for the government and potentially put a strain on the market.

The UK is facing a significant shortfall in its gross financing requirements over the next few years. This is primarily due to the country's large budget deficit and the need to finance its growing debt burden. As a result, the UK government is likely to face increasing pressure to raise taxes and cut spending in order to reduce the deficit.

The government finances its operations entirely through the sale of gilts.

Jamie Searle, rates strategist at Citigroup, wrote in a note that the current issuance challenge is without precedent. He noted that while the market has been discussing the looming jump in gilt issuance for some time, it has yet to feel it directly. However, that all changes from now.

Ten-year bonds fell for a second day on Friday, with yields rising more than 20 basis points from a low on Thursday. This was the biggest jump in yields since late-October.

Although they have fallen from over 4.50% since anxiety over the Liz Truss administration’s fiscal plan was at its peak, the supply outlook points to further weakness down the line. According to NatWest Markets, 10-year yields could hit 4.3% by the second half of next year, more than a full percentage point north of where they were trading on Friday.UK bond issuance hit a record high in the first quarter of 2021, capping gains for traders who have bet on continued austerity measures.

The UK government sold a record £52.5 billion ($73.5 billion) of bonds in the first three months of the year, according to data from the Debt Management Office. That's up from £47.6 billion in the fourth quarter of 2020 and £40.9 billion in the first quarter of 2020.

The surge in bond issuance comes as the UK government looks to finance its response to the coronavirus pandemic. The government has already borrowed £275 billion ($383 billion) to fund its pandemic response, and is expected to borrow an additional £355 billion ($493 billion) in the 2020/21 fiscal year.

The increase in bond issuance has been a boon for traders who have bet on continued austerity measures. UK government bond yields have fallen to record lows, and the cost of insuring against a default on UK government debt has also fallen.

"It's hard to see an environment where the usual buyers of gilts - foreigners and LDI - feel compelled to increase demand to keep pace with supply," said Imogen Bachra, NatWest's head of UK rates strategy. "At these yield levels, natural buyers may be hard to find."

In a recent speech, UK Chancellor of the Exchequer Sajid Javid outlined the economic challenges facing the country as it enters a recession. Javid said that the government is facing a £55 billion shortfall in tax revenue, and that spending cuts will be necessary to make up for this. He also said that the government is committed to helping businesses and individuals weather the economic downturn.

The DMO is set to issue fresh debt this week with an index-linked bond sale. While the deal may do well given there’s going to be less supply of these securities in the near term, strategists still see challenges in the years ahead.

The Bank of England is selling gilts in order to reduce its balance sheet, which includes £835 billion of gilts acquired through quantitative easing, as well as £19 billion bought to stabilize the bond market after September’s meltdown. This is adding to the headwinds faced by the economy.

According to Rohan Khanna, rates strategist at UBS Group AG, there may be reasons to be less bearish on the outlook for gilts if a UK recession and easing inflation pressures enable the BoE to slow or pause its hiking cycle.

"However, if we are incorrect about monetary policy and rates continue to rise next year, then reducing this debt would be difficult," Khanna said in emailed comments.

The Office for Budget Responsibility (OBR) has revised its growth forecast for 2023 down to 1.4% from 1.8% previously. It also expects inflation to fall to 9.1% this year and 7.4% in 2023, though that is still well above the central bank’s 2% target.

After years of borrowing at rock-bottom rates, the government now has to contend with steeper financing needs and rising interest rates. This situation, described as a "false paradise" by an official with the Office for Budget Responsibility, presents a new challenge for the government.

Craig Inches, head of rates and cash at Royal London Asset Management, warned that the market may be heading into a debt funding crisis, just as it recovers from the pension fund liquidity crisis. He noted that even with tax rises and spending cuts, the borrowing picture is even worse than before.