How ‘linkers’ left the British economy dangerously exposed

Jeremy Hunt is celebrating inflation falling to a two-year low, giving him a boost less than a week before he delivers what could be his last Autumn Statement. Lower inflation reduces the size of Britain’s debt interest bill because of the country’s inflation-linked bonds.

However, the Chancellor still faces huge debt payments on the UK’s £2 trillion borrowing pile.

In a series of articles starting on Wednesday, we explain how policy choices and regulatory failures have left Britain more exposed than any other G7 nation to inflationary shocks.

We will also outline how the Bank of England’s money-printing experiment will cost the taxpayer for years to come and what the debt trajectory means for Mr Hunt or Rachel Reeves if she becomes the next chancellor.

“The stock of debt is an acute danger,” says former chancellor Lord Lamont.

While Hunt is expected to slash business taxes and is also eyeing a cut to inheritance tax in next week’s announcement, Lamont says the focus must be on getting inflation down and getting Britain growing again. Unless that happens, the economy risks being swallowed by a mountain of debt.

“When the cost of debt is rising faster than the cash size of the economy, that can be a very dangerous situation.”

Margaret Thatcher successfully faced down a series of worker strikes during her decade as prime minister that helped transform the economy. But it is arguably a gilt strike by financial institutions in the late 1970s and early 1980s that has the largest reverberations today.

Britain faced several “funding pauses” in the late 1970s where investors shunned gilts – as UK government bonds are known – amid concerns that Britain wasn’t serious about controlling inflation.

The Treasury found a novel solution: index-linked gilts. These were government bonds with yields tied to inflation, guaranteeing investors a real return that would be immune to price shocks. Britain was the first major economy to issue “linkers”, which caught on around the world.

The index-linked gilt was born on March 27, 1981. The first £1bn issue had a maturity of 15 years and offered a real return of 2pc.

It was the product of months of talks between the Treasury and the Bank of England, which at the time was responsible for issuing UK debt.

Index-linked debt remained a relatively small part of the market throughout the 1980s. However, that changed with the death of Robert Maxwell in 1991.

The newspaper tycoon had fraudulently appropriated £460m from the Mirror Group’s pension fund to prop up his debt-laden companies.

A knee-jerk reaction by the Government and regulators led to tighter rules for pension funds. Tighter regulation forced funds to keep schemes well funded. Many sold equities and bought bonds as a result, banking on the predictable returns of gilts.

“The Maxwell scandal damaged the credibility of our whole pensions infrastructure,” says Alan Pickering, who led a government review of pensions in the 1990s. “The Government couldn’t find an easy way to abolish theft, but everyone felt like they had to do something about it, so they tried to guarantee compulsory post-retirement incomes instead.

“It wasn’t an antidote to Maxwell, it was just a political fig leaf.”

The shift created a dramatic surge in demand for gilts. Pension funds were particularly keen on index-linked debt given its in-built inflation protection.

The Debt Management Office (DMO), which took over the role of issuing UK debt when the Bank of England became independent in 1997, began issuing 50-year bonds that were tied to inflation to meet huge demand for “linkers”. At one stage, 30pc of all government debt issued was index-linked.

Angela Knight, a former City minister, believes the move away from equities by pension funds was a mistake.

She says: “As the years and decades have passed, we’re now seeing the consequences, both in reduction of the equities held by those pension funds... and a general view that pension fund regulations and requirements have pushed too far towards bonds.”

The UK’s stock of index-linked debt stood at £550bn by the end of 2022, accounting for a quarter of the Government’s debt portfolio. The UK’s share of inflation-linked debt is now the highest in the G7, and double the size of France and Italy.

Officials paid little attention to the growth of “linkers” in the pre-pandemic era. Inflation was low and some economists argued it was a problem of the past.

But Downing Street received a wake-up call in the summer of 2017 in the form of a warning from the Office for Budget Responsibility (OBR).

The OBR pointed out that the share of index-linked gilts had grown from 20pc of total debt in 2007 to 23pc in 2017.

By tying more debt to prices, Britain had left itself dangerously exposed to inflation shocks. Even relatively small moves could trigger significant increases in repayments.

The note alarmed Treasury officials.

Further analysis by the DMO showed that if current trends continued, just under half of Britain’s debt could end up being tied to inflation.

This was not chiefly because of new issuance but an accounting matter: unlike conventional gilts, the value of inflation-linked bonds grows with prices. As a result, the debt could metastasize if inflation were to creep up, representing an increasing share of Britain’s total debt pile.

“The issue had basically flown under everyone’s radar,” says one former Treasury official. “But when we saw the analysis, basically the Treasury and DMO got together and said we should do something about this.”

The DMO’s 2018-19 financing remit recognised that the share of linkers had “consequences for the long-term inflation exposure in the public finances”. Officials announced they would reduce index-linked gilt issuance by two percentage points compared with 2017-18.

This process has continued and the DMO announced in March that just 10.9pc of new debt would be directly linked to inflation, compared with up to 30pc a couple of decades ago.

However, DMO analysis suggests that 25pc of UK debt will still be tied to inflation going forward as the bonds keep going up in value, keeping the UK more exposed to inflation shocks compared with other nations.

The DMO also noted in March that the “Government is no longer looking to reduce index-linked gilt issuance as a share of total issuance on a year-on-year basis over the medium term.”  

Lord Lamont, who was not involved in the creation of “linkers”, describes index-linked debt as a “brilliant innovation at the time”. However, he believes they are now becoming a serious problem and the Government must wean itself off them.

“I wouldn’t issue any more when inflation is high,” he says.

Lord Lamont fears that the days of benign inflation are over, which has huge implications for debt service costs going forward.

“I think we are living in a world where the forces that kept inflation down have lessened or even disappeared,” he says.

“Whether it’s globalisation or China, central banks deceived themselves thinking they had got inflation down.”

Charles Goodhart, a former Bank of England official and founder member of the Monetary Policy Committee, agrees.

Analysis by the DMO suggests that as long as inflation, as measured by the retail prices index (RPI), averages less than 3pc over the life of the bond, the government still gets value for money.

However, RPI inflation has in fact averaged 3.5pc over the past decade, according to the Office for National Statistics (ONS).

RPI is no longer an official measure and the government has taken steps to change the terms of “linkers” so that they are tied to an alternative measure of inflation, CPIH, which includes housing costs, from 2030.

The DMO estimates this could potentially save the taxpayer billions of pounds going forward.

Yet Lord Macpherson, a former permanent secretary to the Treasury, says Britain will still be counting the cost of its inflation bets for decades. The recent surge in inflation has landed Britain with an estimated £94bn bill this year alone – more than the entire education budget.

“It is clear that debt interest payments are a lot higher, and quite a lot of that is to do with inflation,” says Macpherson.

“With the benefit of hindsight you can argue, maybe the Government shouldn’t have issued quite so much [index-linked] debt.”

Appetite for index-linked gilts is expected to wane in the coming years as defined benefit (DB) pension schemes wind down. These schemes, which promise retirees a guaranteed income, are being replaced with simpler savings pots that do not make any promises on future payouts. 

Dan Mikulskis, chief investment officer at the People’s Partnership, which manages £22bn on behalf of six million savers, says: “DB pension funds have typically been big buyers of index-linked gilts to match the pensions they have promised their members, and most industry experts believe this source of demand has now peaked and will be much lower going forward.

“Index linked gilts are not a significant part of our investing strategy for our members”.

However, concerns that the era of low inflation is over linger. If inflation remains above 3pc, then even ending the sale of new “linkers” will not be enough to solve the problem of rising debt service costs.

Index-linked debt has an average maturity of 18.4 years, compared with 13.9 years for conventional gilts, meaning the UK’s long-term inflation outlook matters even more. The Government will still be on the hook for some of its “linkers” into the 2070s.

Goodhart says: “No-one knows the future. But I think that recent developments have thrown the advantage of the government of having issued index-linked gilts into question again.

“For the pension funds, getting rid of the uncertainty about the real value of gilts was an enormous benefit. But for the seller, it really only works if you actually control inflation.”