INVESTING EXPLAINED: What you need to know about: Debt Sustainability

INVESTING EXPLAINED: What you need to know about: Debt Sustainability

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s : Debt Sustainability. 

What is this?

There has always been lots of focus on how much a country or a company owes, but the issue is rising up the agenda.

A country’s debts are regarded as sustainable if it can meet its current and future payments without a bailout or going into default. This is obviously a perennial concern for some developing nations.

But suddenly the sustainability of UK government borrowings is also in the spotlight. The Government is – obviously – not going to renege on these debts. Nevertheless, ahead of the autumn Budget, the topic is going to be increasingly under discussion.

Why is this?

The amount that the UK owes has climbed to £2.58 trillion, thanks to borrowings during the pandemic and the war in Ukraine.

Holding the purse strings: The nation's debts stand at 98.5 per cent of GDP for the first time since 1961

Holding the purse strings: The nation’s debts stand at 98.5 per cent of GDP for the first time since 1961

As a result, the nation’s debts stand at 98.5 per cent of GDP (gross domestic product) for the first time since 1961 – when Harold Macmillan was prime minister.

In 2008, before the onset of the financial crisis, UK debt was about 38 per cent of GDP.

There are now questions as to how the country can shrink the burden following some pessimistic forecasts about the outcome if no action is taken. The independent Office for Budget Responsibility (OBR) warns that the debt total could grow to three-times GDP by the 2070s.

Why do we owe so much?

For lots of reasons. The cost of energy support schemes, inflation-linked benefit payments and interest payments on government gilt-edged bonds (gilts) – fixed-income bonds issued by the Government through the Bank of England to raise money. There is a fast-mounting bill for servicing the payments on index-linked gilts, which account for about 25 per cent of total amount outstanding – the highest in the developed world. The interest on these gilts and the payouts on redemption are both linked to inflation.

In the decades to come, the debt will be further increased by higher state pension payouts as the population ages and by the loss of fuel duty arising from the switch to electric vehicles.

And why should we care?

The threat is not immediate. As inflation falls, the index-linked payouts will begin to decline. But perception matters in the financial markets and it could be that one of the credit ratings agencies decides to downgrade the UK’s credit rating, as Fitch did this month to the US.

This would make borrowing more expensive. The debt also limits No10’s ambition to lower taxes before the general election.

Cuts would mean yet more borrowing. But in the Budget, the Chancellor may try to tackle the problem through spending cuts and strategies to stimulate growth.

Does this make gilts a bad deal?

Not necessarily. Gilts could be an attractive proposition for anyone looking for an income who is also ready to risk. Rising interest rates hit gilt prices, raising their yields The average yield on two-year gilts is 5.19 per cent – the highest for more than a decade.

Investors receive the ‘coupon’ on the gilt and should also benefit from a capital gain when it reaches its maturity or redemption date. An ETF (exchange-traded fund), such as the iShares Core UK Gilts, provides exposure to gilts of a range of maturities.