Expect U.K. Government Bond Yields to Creep Up

 | Feb 09, 2017 | 8:00 AM EST
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Britain has taken another step toward leaving the European Union, with the House of Commons voting to give Prime Minister Theresa May the green light to trigger the process. So, now is is a good time to look at the country's bonds.

U.K. debt has been remarkably resilient after the shock of the Brexit vote, but investors still should stay away from this asset class. The Bank of England has done everything in its power to make debt great again, to use a phrase that is in fashion now, but it may not be enough to keep yields from rising.

Shortly after the June 23 vote, the Bank of England halved its interest rate to a historic low of 0.25%. Despite its mandate to fight inflation, at its recent monetary policy meeting it made clear that interest rates will not increase from that rock-bottom level.

And yet, a look at the way yields on the 10-year bonds of the U.K., U.S. and Germany have behaved lately shows investors' worries about Britain are on the rise. The U.K. 10-year yield has been rising more sharply than the German one, despite mounting fears about the eurozone.

Source: FactSet

The U.K. yield path seems more in sync with that of the U.S. Treasury, even though the Federal Reserve has been engaged in tightening monetary policy for a while now, unlike the Bank of England.

If investors begin to seriously ponder the strain that U.K. public finances are likely to face going forward, these yields could go even higher. For one, the prospect of cutting tax rates so that Britain can compete outside the EU does not seem to have been priced in yet by bondholders. This development would mean less revenues for budget expenditures, and consequently more borrowing.

But even before that occurs, the U.K. budget could suffer death by a thousand cuts -- or, more accurately, death by the numerous demands on the public purse that will be increasingly hard to satisfy. The austerity policy of former chancellor George Osborne has been halted and there are no prospects for more savings, at least not for now.

With inflation rising following the British pound's 17% devaluation after the Brexit vote, it is likely that low-income families will rely on state handouts even more than before. This outcome would be on top of demographic headwinds that already put pressure on the Treasury.

A look at the trend of public expenditure shows that spending on old age-related items, such as pensions and care, has increased every year since 2009. There is no reason to believe this trend will not continue.

Pensions make up 42% of total spending in the U.K., followed by incapacity, disability and injury benefits with 16%, social benefits (such as top-ups for those on low wages and child benefits) taking up 13% of the bill, and housing benefits (rents paid in full or partly for those who cannot afford to pay out of their own pocket) with 10%.

If the U.K. leaves the EU without an agreement on maintaining the rights to public health care for hundreds of thousands of British pensioners living in various EU countries, its own old-age care bill could shoot up. Many of those pensioners will be forced to return and probably will need to be housed and taken care of by the British state. It is impossible to calculate how much that will cost, as it will depend on the way the government will decide to deal with the problem.

The welfare bill will compete with other areas that will need government subsidies, too. Already, the government made a promise to Japanese carmaker Nissan that it would be no worse off when Britain leaves the EU. The exact details of the promise are unknown, but subsidies for various industries to compensate for tariffs on exports to the EU should not be ruled out.

Promises that the U.K. will save £350 million ($440 million) per week if it leaves the EU and that this money will all go to finance the National Health Service (NHS) -- promises that were a cornerstone of the Leave campaign before the referendum -- have been dropped.

The reality is that even if the U.K. does manage to save money by no longer paying into the EU's coffers, it will need to spend it not just on subsidizing various sectors of the economy but on various regions as well. Impoverished areas in the north or in Wales were net beneficiaries of EU funds, and now the U.K. government will need to foot the bill.

On top of the above, the EU demands that Britain settles an exit bill that could be as high as €60 billion ($64 billion), consisting of various commitments the U.K. already has undertaken and of the pensions of its own European Commission employees.

How will the U.K. meet all these additions demands? It will need to issue new debt, obviously. But the U.K. already is running one of the highest budget deficits in the developed world, of around 4% of gross domestic product, and its debt-to-GDP ratio exceeds 86%. The outlook for bondholders just isn't that good. Expect those yields to keep creeping up.

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