Issuing Perpetual Bonds Would Show that Sunak is SeriousFinancial Times, October 31, 2022
After Liz Truss’s disastrous financial performance as UK prime minister, the first task of her successor, Rishi Sunak, is to reassure markets that he is a professional. He must acknowledge the market worries about deficit spending, which were on full display in the turmoil that followed former chancellor Kwasi Kwarteng’s “mini” Budget.
But Sunak must be careful not to impose too much austerity, which could trigger a full-blown financial crisis in a country that is facing many headwinds, including a shortage of affordable housing and a looming pension crisis.
To deal with these problems he has a useful tool at his disposal: issuing perpetual bonds. Sometimes called “war bonds” or “consols”, perpetual bonds have a long history in the UK. They were first issued in 1752, and later used to consolidate the debt accumulated during the Napoleonic Wars (which is why they were called “consols”). These wars pale in comparison with the global distress brought on by Covid-19. Issuing “Covid consols” to help confront the aftereffects of a calamity looks eminently reasonable.
The main advantage of perpetual bonds is that the principal never has to be repaid; only the coupon must be paid while the bonds are outstanding. The current interest rate environment may not seem the best time to issue perpetual bonds because the coupon would be rather high. But that doesn’t matter. The bonds can be redeemed (after a “non-call” period) and replaced with another perpetual bond with a lower coupon. Perpetual bonds are the ideal tool to use to resolve a serious financial crisis like the present one. Not having to repay the principal provides a tremendous advantage that dwarfs the temporary cost of a high coupon. It could help solve both the housing and pension crises.
UK pension funds are struggling to manage their gilts portfolios as interest rates go up and the Bank of England sheds the assets it accumulated during quantitative easing. Pension funds don’t know what to expect from the BoE.
Under QE, the BoE purchased long-term gilts with short-term interest-bearing cash, which has put the bank in a bind. By raising rates to fight inflation, the BoE is simultaneously raising its funding costs and driving down gilts prices. In combination, these will generate large losses for the bank.
If the BoE were shielded from politics, it could ignore these book-keeping losses. Yet these are fraught times; the BoE cannot ignore politics when setting monetary policy, making it harder for pension funds to manage their portfolios.
The Treasury could alleviate the situation by replacing (through a swap) the BoE’s long-term gilts with shorter-term bonds. (For its part, the BoE could reduce what it pays on cash reserves.) This would attenuate the BoE’s maturity mismatch, reduce its exposure to losses and relax the political constraints that make it hard to predict the central bank’s moves. This would be a relief for pension funds.
But it would also shorten the maturity of the Treasury’s debt. The Treasury could offset this by issuing perpetual bonds, which would have the added benefit of creating a single liquid benchmark to anchor the long end of the gilt market. This would address another difficulty pension funds have faced — the relative illiquidity of long-term gilts created by QE. By having the Treasury issue perpetual bonds, Sunak would show that he is serious and so enjoy the support of financial markets.
There is a real danger, however, that the Sunak government may take a more conservative approach. I proposed perpetual bonds in January 2020, when interest rates were much lower. There was no response. I find the reappointment of Suella Braverman as home secretary disturbing. Restricting immigration will raise wage costs and fuel inflation. If this is the route Sunak is choosing, the prevailing optimism in financial markets will not be justified.