Market Analysis

A Close Look at the UK’s Inflation-Linked Debt

Interest payments are up, but so are revenues.

Is the UK slipping into a debt crisis of its own making? Commentators we follow have begun asking this question in the wake of a new report showing the UK has more debt with inflation-linked interest payments than any other major country.[i] With floating-rate debt constituting nearly 25% of overall outstanding Gilts, it is more in line with many Emerging Markets than developed, according to recent research.[ii] The relatively high share wasn’t historically a problem, but recent hot inflation (economy-wide price increases) has ratcheted up interest payments, leading many commentators we follow to argue public finances could be in trouble. And it is true, payments have jumped.[iii] But we see some mitigating factors we think are widely ignored, suggesting to us there is a high likelihood these warnings won’t come to fruition, which likely helps UK stocks keep climbing.

In a vacuum, we can see why the raw numbers don’t look great to many observers. Exhibit 1 shows UK central government interest payments on a rolling 12-month basis, with conventional and inflation-linked (aka index-linked) Gilt interest payments separated. Total interest payments have more than doubled since 2020, and index-linked Gilts are responsible for the vast majority of this.

Exhibit 1: Central Government Interest Payments (Trailing 12-Month Basis)


Source: Office for National Statistics (ONS), as of 24/7/2023. Monthly central government interest payments and index-linked Gilt capital uplift, April 1997 – June 2023. Data are shown on a trailing 12-month basis. Gilt capital uplift refers to the portion of interest payments stemming from the change in the Retail Price Index, which is the price measure used to calculate payments on index-linked Gilts.

Yet interest payments aren’t the only thing inflation has driven higher. Tax revenues are also up.[iv] Inflation has hit all points of the supply chain, which is painful for consumers and producers alike, but it also raises value-added tax (VAT) revenue, since VAT is assessed on higher prices at each stage. Inflation has also driven wages higher, boosting income tax revenue.[v] Higher interest rates have boosted investment tax revenue, too.[vi] We aren’t arguing this is pleasant for the households and businesses having to pay up—it likely isn’t—but in our view, it is a silver lining for public finances, as Exhibit 2 shows.

Exhibit 2: Central Government Total Current Receipts (Trailing 12-Month Basis)


Source: ONS, as of 24/7/2023. Monthly central government total current receipts, April 1997 – June 2023. Data are shown on a trailing 12-month basis.

As a result, interest payments’ share of tax revenues—whilst up—is roughly in line with most of the 1980s and the 1950s.[vii] The 1980s were a great time for the UK economy and markets, which participated in a global boom.[viii] From a societal standpoint, we think it is fair to say the 1950s were much tougher, with the aftermath of the Suez crisis and WWII reconstruction testing the population, but then, too, the economy demonstrated remarkable growth and resilience, in our view.[ix] On both occasions, strong nominal gross domestic product (GDP) growth helped lift revenues and reduce the relative debt burden, and we don’t see much foundation to argue this time is different.[x] Actually, as Exhibit 3 shows, the ratio has seemingly started rolling over already.

Exhibit 3: Central Government Interest Payments as a Percentage of Revenues (Trailing 12-Month Basis)


Source: ONS, as of 24/7/2023. Monthly central government interest payments divided by total current receipts, April 1997 – June 2023. Data are shown on a trailing 12-month basis.

In our view, simple debt management tools can also help alongside economic growth. £22 billion worth of index-linked Gilts mature next year, and if it chooses, the Debt Management Office (DMO) can refinance them with conventional Gilts.[xi] It has already reduced the share of newly issued bonds that are index-linked and could do so further.[xii] Even if it does choose to do a one-for-one refinancing with index-linked Gilts, simply getting the old ones off the books cuts down interest payments, as the new securities won’t have prior inflation baked into their interest payments.[xiii] They are therefore a clean slate. Plus, the DMO (in our view, wisely) locked in lower borrowing costs on conventional Gilts these last several years, giving a large buffer before higher interest rates have a meaningful impact on total borrowing costs.[xiv] The weighted-average maturity of all conventional Gilts outstanding, as of Q1’s end, was just under 14 years.[xv] That means interest rates would have to soar and stay there for a very long time before the vast majority of the debt stock was subject to high rates.

We suggest not underrating how this wiggle room, combined with nominal GDP growth, can rein in total debt service costs without severe austerity, contrary to today’s chatter. Growth can be a powerful debt reduction tool. It cut high debt burdens in the US and UK alike in the post-War era and is starting to do so now, despite the scant attention we have seen this receive.[xvi] Warnings of trouble may hit headlines for now, but as time proves them false, the gradual relief will likely be a tailwind for UK stocks, in our view.

[i] Source: Office for Budget Responsibility, as of 26/7/2023. Inflation is broadly rising prices across the economy.

[ii] Source: Bank for International Settlements, as of 24/7/2023.

[iii] Source: Office for National Statistics (ONS), as of 24/7/2023.

[iv] Source: ONS, as of 24/7/2023. Monthly central government total current receipts, April 1997 – June 2023.

[v] Source: ONS, as of 26/7/2023. Statement based on UK nominal wage growth, year-over-year, June 2020 – June 2023.

[vi] “Rising UK Interest Rates Threaten Sunak’s Fiscal Plans, OBR To Warn,” Richard Partington, The Guardian, 12/7/2023.

[vii] Source: ONS, as of 24/7/2023. Annual central government interest payments divided by total current receipts, December 1949 – December 1989.

[viii] Source: ONS and FactSet, as of 28/7/2023. Statement based on MSCI UK IMI annual total returns and annual gross domestic product, or GDP, which is a government-produced measure of economic output, 1980 – 1989.

[ix] Source: ONS, as of 24/7/2023. Statement based on annual GDP growth, 1950 - 1959

[x] Source: ONS, as of 26/7/2023. UK yearly GDP growth, 1949 – 1989.

[xi] Source: Debt Management Office, as of 26/7/2023.

[xii] Ibid.

[xiii] Per the DMO, index-linked Gilts’ payouts are based on the cumulative change in the Retail Price Index since the bond’s issuance.

[xiv] Source: DMO, as of 24/7/2023.

[xv] Ibid.

[xvi] Source: Office for National Statistics and St. Louis Federal Reserve, as of 24/7/2023.

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