Old Mill Updates

Coronavirus and government debt

As the coronavirus crisis progresses, there has been huge spending commitments by governments worldwide and a massive financial stimulus by central banks prompting some to be concerned about how all of this borrowing will be repaid.  Whilst most agree the spending is unavoidable, only time will tell what the long-term implications of this will be on the global economy.

7th April 2020

The Institute for Fiscal Studies (IFS) splits the estimated coronavirus cost to the UK into three elements:

  1. Impact of a smaller economy
    The IFS assumes the economy will shrink by 5% in 2020. That contraction and the resultant fall in tax revenue alone accounts for increased borrowing in 2020/21 of £72bn.
  2. Direct cost of fiscal measures implemented in response
    An estimate for the Coronavirus Job Retention Scheme (CJRS) and the self-employed equivalent is £60bn. The suggestion from the Deputy Chief Medical Officer, that social distancing may last six months, would add about £20bn to that figure.
  3. Loans, guarantees and deferrals
    The government has promised £330bn of loan guarantees, but what that will cost depends on loan take up and subsequent calling in of the guarantee.

The IFS suggest that, based on a three month lockdown, an extra £130bn will be added to borrowing in 2020/21, taking it to about £190bn (around 9% of a reduced Gross Domestic Product. However, the IFS say, ‘There is a substantial chance that borrowing will turn out considerably more than this if the economic hit is greater or a large fraction of private sector employers take advantage of the employment retention scheme.’ The peak borrowing during the financial crisis in 2009/10 was 10.2% of GDP.

An increase in taxes

Beyond 2020/21, the IFS suggest that, even if coronavirus is behind us, ‘…the tax and spend trade-offs facing policy makers will be made more stark for years, and more likely for decades, as they strive to bring debt back down over the longer-term’.

The government’s manifesto pledge not to increase the rates of Income Tax, National Insurance Contributions (NICs) and VAT could well become another victim of coronavirus. The Chancellor, Rishi Sunak, recently gave a clear hint that NIC rates could be moving up for the self-employed, but an extra 1% on all Class 4 NICs would only raise about £0.6bn, according to HMRC. 1% on Income Tax rates and VAT and all NICs raises about £6bn-7bn.

Stimulus around the world

Globally, the picture is the same with the European Central Bank offering €billions and the Fed offering $trillions in loans and asset purchases. An agreement on the US government support package agreed at the beginning of week commencing Monday 23 March was instrumental in temporarily restoring market confidence. In this regard, countries had learnt from the Global Financial Crisis of 2007-2009 where government support was slow and incremental. This time announcements have been made swiftly and without any doubt that governments and central banks will do whatever it takes.

High levels of government borrowing has been a feature of (some) developed countries for many years but countries may face problems ahead if their level of debt becomes unsustainable.

Only time will tell if monetary policy enables a swift global economic recovery, or as it seems increasingly likely, at least a short-term recession. The unknowns are the progress of the virus, developing treatments and, in time, a vaccine.

Sovereign debt

We have already seen price movements in company debt known as corporate bonds but with huge levels of additional borrowing, we may see ratings changes for the government debt of some countries. We can diversify against this by having a global spread of debt and monitor the ongoing situation.

Why ratings matter

Credit rating agencies, in essence, rate a country on the strength of its economy. More specifically, they score governments (or large companies) on how likely they are to pay back their debt.

Ratings affects how much it costs governments to borrow money in the international financial markets. In theory, a high credit rating means a lower interest rate (and vice versa).

AAA, is the highest possible rating that may be assigned to an issuer’s bonds by any of the major credit rating agencies. AAA rated bonds have a high degree of creditworthiness because their issuers are easily able to meet financial commitments and have the lowest risk of default.

As an indication, the UK government has an AA rating from most agencies indicating a strong likelihood that it will be able to repay borrowing in the future.

Criticisms of ratings agencies

In the Global Financial Crisis agencies were criticised by being slow to react when organisations were getting into financial trouble. At the time investment managers learnt to understand the risk in a particular debt issue by the bond price —as reflected in bond yields or credit spreads (the yield difference between bonds of similar maturity but different credit quality).

Today this provides a supplemental and continuously updated source of information about bond credit quality. Every day, numerous market participants assess the credit quality of fixed income securities using all the information at their disposal. As a result, bond prices should reflect the market’s assessment of differences in credit risk.

Managing risk in practice

These results support the use of up-to-date market prices to improve credit risk monitoring. Dimensional, the manager of our current short dated, high quality bond fund, have developed a robust and systematic credit monitoring process that takes into account information from stated credit ratings, as well as current bond prices, to constantly monitor the implied risk of those bonds. For instance, if a bond is trading at substantially higher yields than its same-rated peers, Dimensional may assign that bond a lower internal rating than its stated credit rating. If the internal rating is inconsistent with the goals and constraints of a strategy, which we may see as a government get into financial difficulties, that bond may not be eligible for purchase in our lower risk strategy.

We know you want reliable portfolios with robust risk controls. This market-informed credit assessment provides a more complete picture of an issuer’s credit quality in real time, helping to ensure that Old Mill portfolios remain robust.


If you’d like to know more about the approach we take to Financial Planning and our Investment Portfolios please talk to us.