We are yet again ignoring economic developments in favour of taking another look under the bonnet of what drives your asset planning. The topic is dry, but lies at the very core of our collective material wellbeing. As usual we will first set the scene, and then focus on how it might affect us all. 

Gilts have been used by Government since 1693 to finance expenditure not covered by tax receipts. The UK debt mountain has soared with excessive public spending, and much of the receipts from sales of new gilts is needed to pay interest on the old. This, and the reckless antics of banks, encapsulates the current economic crises. Levels of Government and bank debt are overwhelming, and the fat lady is singing. 

When you owe huge (any!) sums the interest rate you pay is key. Unlike our Eurozone friends the UK controls its own governance and interest rates, and if we run out of money we can always print more via quantitative easing (under which the Bank of England creates new money to buy gilts – a legal form of Ponzi Scheme). The UK is consequently considered to be creditworthy, and a “safe haven”. 

Looking at benchmark 10 year bond yields the UK’s current cost of borrowing (what investors demand to invest in gilts) is sub 2%, as it is in the US and Japan (other “safe havens”). Recent EU averages are 3% in France, 5% in Spain and 7% in Italy with Greece a snip at 35%. Hence the sovereign debt crises – countries are forced to borrow at elevated interest rates to repay debts that were already out of control. 

To surface from beneath its vast excess debt the UK’s ability to borrow cheaply is vital, and the coalition’s austerity measures (and not being in the Euro) have helped. But the economy must now grow to generate the higher tax revenues required to enable debt to be paid down; a wicked case of Catch-22 since economic growth is rarely synonymous with recessions suffered both at home, and by trading partners. 

The UK enjoys an AAA credit rating; a major reason why our costs of borrowing are so low. But we chaps fail to see how we can retain this throughout 2012, as we borrow more and more in the teeth of recession and austerity. If we drop an “A” borrowing costs (as in gilt yields) should rise, and gilt prices fall. Europe is in the grip of a vicious debt spiral, and we are susceptible to theirs as well as our own. 

Gilts are like the final base camp on Mount Everest – you cannot go much higher, but there is a hell of a long way to fall. Sooner or later higher costs of borrowing and/or resolution of the debt crises will likely decimate gilt prices. As we have long been saying personal exposure should be avoided (it will be on our watch) albeit it will be impossible to avoid the indirect impacts (which we will cover another time). 

Our second “so what” is that annuity and pension drawdown rates are largely sourced from medium term gilt yields; hence why those currently starting to take income from pension funds (or undergoing a drawdown income review) are being badly squeezed. For these folk gilt yields rising will actually be a blessing – to the extent, of course, that their pension fund had not been invested in gilts. 

Our third “so what” is good news for pensioners. The coalition has announced that for the purposes of calculating pension drawdown rates the determining 15 year gilt yield will be “floored” at 2%. The 15 year yield is currently 2.51%, so income can reduce from here – but only so far. Having said which, were the 15 year yield to slip below 2% the pension “floor” may not compensate for dire consequences elsewhere…..