What are bonds? Meaning of term and what are index-linked gilts as UK government borrowing costs soar

Government borrowing has continued to break records despite coming in lower than expected in July, the latest Office for National Statistics (ONS) figures have shown.

Following the news that the deficit soared to its fourth highest level on record during the last financial year, the latest update suggests Rishi Sunak and his Chancellor Jeremy Hunt are facing an uphill struggle at the next general election. Not only are the government’s five targets for 2023 in danger of being missed, but the Conservatives are unlikely to be able to launch a public spending and tax cutting spree ahead of the next national poll.

One of the big reasons for this is that interest payments on government debt have hit an all-time high for the month of July. The figure of £7.7 billion is £1.5 billion higher than the figure in the same month last year.

National debt has become so expensive over the past 12 months due to two key things: record inflation and political turmoil. While the former has increased the returns investors are due from government debt, the latter has also proven to be costly given it has made investment in the UK’s debt appear riskier.

The vehicles through which the government borrows money are known as bonds, or gilts. But how do these mechanisms work? Here’s a quick guide.

What are gilts?

Bonds, or gilts, are vehicles for borrowing money. They are essentially debt in the form of a product that can be bought up by a third party in exchange for a particular return over a set period of years or decades. Investors typically get their money back, plus interest.

While bonds can be issued by private sector companies, the term ‘gilts’ is specifically attached to government borrowing. The reason why probably stems from the term the word derives from - ‘geld’. In Anglo-Saxon and then Norman times, geld was a tax paid to England’s kings and queens. Another type of geld - ‘Danegeld’ - was used to pay off Danish invaders in the late 10th and early 11th centuries.

Geld morphed into ‘gilt’ at some point in the 1300s, with the newer term referring to gold or money. The modern meaning of the term came into being during the reign of William III - or William of Orange (1689 to 1702).

Merchants who ran some of the UK’s first-ever companies loaned the government money to finance the country’s war with France. They did so through the Bank of England, which had been founded to bank for the government in 1694. This arrangement saw these early investors paid back via specific taxation. Over the years, this system has evolved so that those providing these loans can make a particular amount of money off them in the form of interest.

Gilts are usually considered to be a low-risk form of investment because they are long-term commitments and come from the government, which can never truly go bust. The government has also historically not issued vast quantities of them all at once with no longer-term financial plan or independent forecast - until Kwasi Kwarteng became Chancellor at least. This has meant that the value of gilts has rarely changed at a rapid pace.

What was the Bank of England bonds intervention?

The Bank of England’s primary roles are to keep the value pound sterling stable and ensure the UK economy remains on an even keel. Essentially, it safeguards our purchasing power and makes sure our money is protected when we invest or save it.

When Kwasi Kwarteng’s £45 billion in tax cuts and the hefty bill for Liz Truss’s energy price guarantee were announced, it led the markets to believe that the government was about to launch a major public borrowing exercise. The Mini Budget’s lack of an Office for Budget Responsibility (OBR) forecast and a longer-term government spending plan, as well as a promise from the Chancellor that more tax cuts were coming, also led to market concern about further unfunded borrowing down the line.

It brought about a major fall in value for government gilts while investors demanded bigger returns for what they felt had become a riskier investment. It meant that pension funds, which buy up and trade a significant amount of government bonds, were suddenly at risk of going under, while the cost of government borrowing was set to soar.

The situation led the Bank of England to intervene as it said there was a “material risk to UK financial stability” because it could lead to “a reduction of the flow of credit to the real economy”. Essentially, the general public’s money and businesses were at risk.

The UK’s central bank announced it would buy up £65 billion of government bonds between 28 September and 14 October in a bid to stabilise the market. But with this deadline looming and no economic plan due from the then-Chancellor until Halloween, investor concerns were threatening to create fresh market turmoil.

Indeed, pension bosses said they were keen for the central bank’s support to be extended, warning the package was ending “too soon”. But this request was denied by Bank of England governor Andrew Bailey.

On 10 October, the Bank of England doubled its daily bond-buying limit to £10 billion. The following day, it followed up this exercise with an expansion of the kind of gilts it was buying up - adding index-linked gilts to its emergency package. Index-linked gilts are bonds whose value and payouts are determined by the Retail Price Index (RPI) - a measure of inflation calculated by the Office for National Statistics (ONS).

The Bank of England said this action was necessary to avoid a “fire sale” (i.e. rapid sell off) of government bonds and “to restore orderly market conditions”. It came after longer-term bond yields - the returns demanded by investors for buying up decades-long government gilts - had rocketed.

While the move calmed markets, commentators said the central bank’s actions suggested it was still in firefighting mode, rather than in control of the situation. Neil Wilson, chief market analyst at Markets.com, said the Bank’s third intervention “seems rather messy and panicky”. He added: “As expected the market was always going to retest the Bank’s resolve and put the budget to the sword. To expand your emergency intervention in the market once is unfortunate, to do so twice looks like carelessness.”

With Liz Truss’s departure from Downing Street and the Rishi Sunak administration’s Autumn Statement, the situation calmed to the extent that no furether Bank of England bond buying action was deemed necessary.