Who buys all the gilts?

The volatility seen in sterling fixed income markets in recent months is unprecedented in the last half century. The political upheaval that has seen four Chancellors in a calendar year has subsided, but challenges for the gilt market remain.

Assuming the Bank of England (BoE) sticks to its plan to reduce gilt holdings by £80bn a year, the UK public sector[1] needs to raise more than £500bn of debt on a net basis over the next two fiscal years. That’s more than triple the previous record net issuance over a two-year period, and a cumulative 20% of GDP.

This new blog series seeks to address two simple questions: who buys it all, and on what terms? In today’s post, I’ll outline the issuance challenge at hand and introduce the potential buyers we see.

The issuance challenge

On a net basis, issuance from the government is set to increase to nearly £200bn per annum by the 2024/25 financial year. However, unlike previous episodes of large net issuance, the BoE is intent on shrinking its balance sheet through a combination of not reinvesting maturities as they fall due and actively selling securities from its portfolio. This gilt issuance challenge facing investors is captured neatly in the chart below.

The balance sheet reduction is not expected to stop until the Bank of England hits its “preferred minimum range of reserves” in 2026 or later.[2] So, unlike in previous episodes, the supply of government liabilities needs to be absorbed by someone in the private sector either domestically or overseas.

So who could be on the other side of that increase?

Insurers and pension funds: These buyers have historically absorbed the lion’s share of gilt supply. We estimate that pension funds currently hold £1000bn of government securities. Although the summer’s market volatility saw significant gilt sales, scheme hedge ratios have fallen and funding ratios have improved. Pension fund demand of £50bn per annum seems plausible after considering both re-hedging and asset allocation shifts.

Banks: UK banks have an unusually limited ownership of the sovereign bond market. Reserves held at central banks are the core of banks’ high-quality liquid asset portfolios. Now that the BoE is reducing the size of its balance sheet, the stock of reserves held by banks will fall. However, if banks replace their disappearing reserves with gilts, additional annual demand of £100bn seems possible provided the issuance profile is suitable (i.e. shorter-dated) and the incentives are right (i.e. gilt yields above the rate at which banks can lock-in funding costs).

Overseas buyers: We think the proportion of the gilt market held overseas is likely overstated in official data. Although in theory there’s a market for UK government debt from foreign buyers, relying on the ‘kindness of strangers’ and hoping for strong overseas demand does not seem realistic given that other governments face similar issuance challenges in the years ahead.

UK funds industry: The UK money market industry has grown by 160% since 2009 to £250bn. The stock of treasury bills outstanding is unchanged over that time at £50bn. We believe money market funds can easily absorb another £10bn a year if the DMO is prepared to increase their allocation in the overall funding mix. As with banks, the potential demand from money market funds could increase with more flexibility in the supply of shorter-dated debt.

Households: At end of the 2021/22 financial year, there was £200bn outstanding of National Savings and Investment guaranteed bonds, income bonds, premium bonds, savings certificates and savings accounts. A stretch target is to assume that NS&I’s net remit is set at £30bn per annum over the next two fiscal years.

[1] https://www.bis.org/review/r221104k.pdf

[2] Including the Bank of England (BoE), the Debt Management Office (DMO) and National Savings & Investment (NS&I)