Doomed if interest rates go up? The UK government already spends £49 billion on debt interest

At a mind numbing £1.8 trillion, the UK government’s debt continues to creep up. Is Britain hurtling towards a default, or are the numbers more manageable than we think?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Interest rate

It’s possible the Bank of England (BoE) will raise interest rates again in August, and so a lot of attention continues to be paid to the UK government’s debt and what might happen if interest rates rise from historically low levels. Can the public finances take the strain?

Ignoring off—balance sheet liabilities (such as future pensions) UK public debt is approximately £1.8 trillion. Therefore, conventional wisdom suggests that a 1% rise in interest rates will require taxpayers to stump up another £18 billion to cover debt—servicing costs. As we will see, conventional wisdom is overly pessimistic on this occasion. 

While rising interest rates are definitely of concern to those with ‘floating rate liabilities’ (i.e. those with non—fixed mortgages and unsecured borrowings), the government is in a slightly different position. UK debt has doubled over the past decade, but crucially the BoE has also extended the average maturity of that debt, much of the demand coming from pension funds, to lessen the impact of interest rate rises.

What is the average interest rate on government debt?

As of the end of 2016, the government declared debt of £1600 billion was made up of 63% conventional gilts, 24% index—linked, 4% treasury bills (debt shorter than one year) and 9% national savings and investments (NS&I), which includes premium bonds. This mix would not have changed by much at the time of writing.

The majority of the UK’s debt is in conventional gilts, which has an average maturity of circa 15.7 years, meaning that if it was evenly distributed we could expect a little over 6% of it to be re—financed every year alongside additional issuance required to finance the budget deficit (in actual fact the debt is slightly skewed towards the near—term).

Taking the iShares Core UK Gilts ETF (IGLT), which tracks a UK government debt index, we can approximate what the current cost of the debt is by looking at the weighted average coupon of the underlying holdings. This comes out at 3.35%, which is rather higher than today’s (July 2018) 1.7% cost of issuing new 30—year debt. Thus, depending on which bond is maturing, it is it is highly probable that the cost to the taxpayer of re—financing debt will continue to fall for some time. 

An example of this is the £36.35 billion 4.5% bond that redeems in July 2019. At present the yield to maturity is 0.5% (resulting in the bond trading at 102.63), making it a certainty that this bond will be re—financed at lower cost. 

Inflation—linked bonds (admittedly a little more complicated due to retail price index (RPI)—linking) are even longer dated, with a weighted average maturity of 23.4 years, some of which are not payable until 2068 — a full fifty years’ time.

The headline writers also often forget that rising interest rates are not a binary good or bad outcome. Rate rises in response to either mild inflationary pressures or simply to cool a growing economy should have their impact offset by increasing tax receipts. Indeed the higher inflation is, the higher tax receipts should be. 

Inflation is playing its part in slowly reducing the debt in nominal terms. In 2018 the debt should increase by around 2%, but inflation is closer to 3%, meaning the debt is really beginning to shrink in real terms. This is the key to future prosperity. As long as the economy can grow faster in nominal terms than the debt increases, then the debt as a percentage of gross domestic product (GDP) will start to fall.

What happens when quantitative easing ends?

Interest payments are not actually as high as the headline of this article suggests, as this overlooks the fact that around £13 billion a year of those payments are made to the BoE, which owns approximately 25% of the total debt outstanding and returns that money to the government.

When quantitative easing is halted, the gilts that the BoE own will simply be allowed to run down normally, with the bank receiving its final coupon and principle payment in the same manner as any other bondholder. It is highly unlikely that the BoE would suddenly flood the market with a surplus of gilts causing bond prices to fall and yields to rise.

The key to an orderly unwind is whether there will be enough buyers to re—finance the BoE’s maturing bonds. This necessitates a healthy economy, but as long as life companies and pension funds hold gilts to cover their liabilities there will be a willing buyer.

Get your free beginner's guide to investing

●  Discover the benefits of investing your money

●  Learn about the different investment options available and how to get started

●  Understand how to build a diversified portfolio and manage your risk

Form has failed to submit. Please contact IG directly.

  • I’d like to receive information from IG Group companies about trading ideas and their products and services via email.

Get my guide

For more info on how we might use your data, see our privacy notice and access policy and privacy webpage.

Form has failed to submit. Please contact IG directly.

  • I’d like to receive information from IG Group companies about trading ideas and their products and services via email.

Get my guide

For more info on how we might use your data, see our privacy notice and access policy and privacy webpage.

●  Discover the benefits of investing your money

●  Learn about the different investment options available and how to get started

●  Understand how to build a diversified portfolio and manage your risk

Get your free beginner's guide to investing

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.