Martin Seale

 

The mainstream media is full of stories about bonds.  The fear being spread is that the Labour government will be unable to sell UK government bonds to a private sector that is apparently worried about whether the UK government might go bust.

The UK mainstream media is unimpressive at the best of times.  But when they talk about UK government bonds, gilts, they display startling levels of ignorance.  Let’s try and explain it to them

What Is a Bond?

A bond is simply a piece of paper (these days, usually just an electronic record) that promises to make a set of payments in the future.

Every bond has three main features:

• Face value — say, £100. This is the amount you’ll be paid back at the end.
• Interest rate — say, 5% per year. This is called the “coupon.”
• Maturity date — say, 5 years from now. This is when you get your £100 back.

So if you bought this bond, you’d receive £5 a year for 5 years, and then a final payment of £100 when it matures.

UK government bonds have a special name: gilts.

Where Do Bonds Come From?

When the government spends more money than it collects in taxes, an office inside the Treasury called the Debt Management Office (DMO) sells, or “auctions,” bonds to match that gap.

Here’s the important part: selling bonds is a choice, not a necessity. By the time the bonds are auctioned, the government spending has already happened. Selling bonds isn’t what allows the government to spend more than it raises in tax.

So How Does the Government Actually Pay for Things?

To understand that, you need to know how government spending is financed in the UK.

When Parliament approves a piece of spending, the Bank of England (BoE) creates new money and puts it into the government’s account. This is how all UK government spending is paid for — the Bank simply creates the money needed, without first checking whether the government’s account already holds enough.

What Happens to That Money Next?

Once the government spends that new money — buying goods and services from private companies — the private sector ends up with more wealth than before. This is a direct link: an increase in government debt is matched, pound for pound, by an increase in private sector wealth. The only way to reduce government debt is to reduce private sector wealth by the same amount.

The private sector then has to decide what to do with this new money. Some gets spent, some gets paid in tax, some gets invested, and some gets saved.

Why Do People Want to Buy Bonds?

When people save money, they usually want to earn interest on it — and this is where government bonds come in. They let people put their savings into a financial asset that pays interest and carries essentially no risk.

Savers could instead put their money into the stock market or into bonds issued by companies, but those are riskier than government bonds. The markets know that the UK government will never fail to pay back its bonds.

So when the government auctions bonds, it isn’t scrambling to find money to spend — that money was already created by the Bank of England. What it’s really doing is offering a safe, interest-paying home for the savings of people and institutions that already have more money than they need.

When People Don’t Want to Buy Bonds

Sometimes the private sector doesn’t want to buy government bonds. This usually happens for one of two reasons:

• They think there’s somewhere else safe to put their money that will earn a betterreturn.
• They expect that, in the near future, new bonds will be issued paying a higher rate of interest.

That second point depends heavily on what interest rate people expect the Bank of England to set in future — which, in turn, depends on what they expect inflation to do.

A Quick Example: Prices and Yields

Imagine investors believe interest rates are about to rise — say, from 2.5% to 2.75%. It wouldn’t make sense for them to pay the full £100 face value for a 5-year bond that only pays 2.5% a year, when a better rate might be available in a month.

So instead, they might offer less than face value — say, £98. They’d still receive £2.50 a year in interest, but on an outlay of only £98. Their effective interest rate — called the yield — works out at 2.5 ÷ 98, or roughly 2.55%.

What’s Actually Happening Right Now

This is exactly the situation we’re seeing today. Markets expect inflation to rise, partly because of the war in Iran. Higher inflation, they believe, will push the Bank of England to raise the interest rate it pays to commercial banks on the money those banks hold with it (held in what are called, for historical reasons, “reserve accounts”).

The media gets excited when bond prices fall, presenting it as proof that markets doubt the government will repay its debts. But that’s not what’s really going on. Markets have simply worked out that, given their expectations for inflation and interest rates, then the value of the bond will fall once the BoE increases interest rates.  It also means that the value of all other bonds will fall.  So there is a rush to sell bonds with the intention of buying back into to market once the intentions of the BoE become clear.  There is no fear in the markets that the UK government will default on its debt.  They are just engaged in maximizing their return.  As you would expect.