Tories Mulling More Borrowing May Threaten World-Beating Gilts

  • Policy proposal may mean additional supply for investors
  • Longer-dated bonds return more than 20% on rates, haven demand

With the race to be Britain’s next prime minister down to three candidates, holders of the world’s best-performing bonds are getting a taste of what may be in store as policy shifts to deal with the economic consequences of voters’ decision to leave the European Union.

Business Secretary Sajid Javid, a supporter of front-runner Theresa May, has proposed selling an additional 100 billion pounds ($130 billion) of gilts to fund infrastructure projects as one way to safeguard growth. First mooted by Stephen Crabb before he dropped his own leadership bid this week, the plan may translate into more debt for investors to absorb and test the demand that has propelled U.K. sovereign bonds to a 14 percent return this year and pushed yields to record lows.

A Tory move toward fiscal stimulus would represent a break from Chancellor of the Exchequer George Osborne’s deficit-reduction efforts, even though he has since abandoned a plan to return to a budget surplus by 2020. A consultation on introducing 100-year bonds was considered in 2012 as part of the plan, only to be dropped later after the Debt Management Office concluded it lacked “tangible market demand.”

Javid, who previously worked at Deutsche Bank AG before entering Parliament, has also served as a Treasury minister. None of the candidates have made such explicit proposals on government borrowing.

‘Can’t Pretend’

“Some supply will be readily absorbed, particularly if the BOE restarts its quantitative-easing program, but I can’t pretend to say that 100 billion pounds is fine,” said David Tan, London-based head of rates at JPMorgan Asset Management, which oversees about $1.7 trillion globally. “There’s no magic number. The answer is conditional and dependent on many moving parts.”

While the pound has borne the brunt of investors’ anxiety about the outlook for the U.K. economy since the June 23 referendum, sliding to 31-year lows this week, demand for gilts has been insulated by the prospect of lower interest rates and new asset purchases. The DMO sold 2026 bonds at a record-low yield Thursday, two days after auctioning five-day debt, also at lowest yield on record. The U.K. is due to sell 131.5 billion pounds of gilts in the 2016-17 fiscal year.

Gilts with due dates of at least 10 years have returned 22 percent this year, compared with an average 14 percent across the euro area, according to Bloomberg World Bond Indexes.

Rates Wagers

The gains were given fresh impetus last week when Bank of England Governor Mark Carney said officials will probably have to ease policy over the summer. Futures trading implies an 89 percent chance of a rate reduction this year. The economic challenges were highlighted this week by a survey showing a slide in business confidence and some money managers announcing the closure of property-investment funds.

Depending on how any proposal to raise money through gilt sales would be implemented, it may not all be bad news. It may satisfy demand from pension companies that need longer-maturity debt to match liabilities and also provide them alternatives to shorter-dated yields that are at historic lows.

Even though the spread has dropped to its narrowest since 2008, yields on 30-year bonds are 1.45 percentage points more than those on two-year gilts. A similar gap in Germany is about 1 percentage points. Benchmark 10-year gilt yields were little changed at 0.77 percent Thursday, ending a six-day drop.

“Currently, the U.K. is seen as a safe haven in the world,” said Darren Ruane, a fixed-income manager at Investec Wealth & Investment Ltd. in London, which oversees 27 billion pounds. “It has its own independent monetary policy system and a strong rule of law. As a result, there should be demand for new gilts providing they are drip fed into the market over time.”

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