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November 22, 2021updated 27 Jul 2022 3:02pm

Sustainability-linked bonds could help solve UK inflation woes

As one of the more eager issuers of bonds linked to inflation, the UK faces the prospect of higher borrowing costs as high inflation begins to look less temporary than initially expected. Sustainability-linked bonds, relatively new instruments, could provide a long-term antidote.

By Chris Papadopoullos

Sustainability-linked bond, inflation

Should the Bank of England put further issuance of index-linked gilts on hold? (Photo by malamus-UK via iStock)
  • Inflation in the UK is proving more stubborn than many economists initially forecast.
  • Inflation adds to the UK’s debt interest via index-linked gilts, which link both interest payments and principal to inflation.
  • Sustainability-linked gilts, which link interest to sustainability targets, would be cheaper to service and more scalable than green bonds.

UK inflation has hit a ten-year high of 4.2%, according to figures released by the Office for National Statistics last week. It is widely expected to climb further – the Bank of England’s new chief economist Huw Pill said he would not be surprised if the rate soon reached 5%.

This poses a risk to interest payments on the UK’s national debt through the UK’s index-linked gilts, where both interest and principal are linked to inflation. There are currently £491bn ($659.5bn) of index-linked gilts in issue, according to the Debt Management Office – the executive agency responsible for debt and cash management for the UK government – accounting for nearly a quarter of the UK’s £2.1trn stock of government bonds.

The Office for Budget Responsibility (OBR), the UK’s fiscal watchdog, estimates that a one percentage point rise in inflation raises the interest on index-linked gilts by £5bn over the next year. If the Bank of England were to respond by raising interest rates, interest would go up further, with debt interest rising a further £10bn in the first year after a one percentage point rise in the bank rate. If inflation hovers around 4–5% and the Bank of England raises interest rates to around 1–2%, debt interest could easily surpass 3% of GDP, the highest since the 1990s.

Public pocket-friendly

Inflation has already caused a rebound in government debt interest via index-linked gilts, with the OBR expecting interest costs to reach £40bn in the current fiscal year, equal to 1.7% of GDP. The OBR then sees debt interest flatlining, but this is because it sees inflation falling – it generally assumes the Bank of England will hit its inflation target within its five-year forecast period. However, this may no longer be a safe assumption; many economists are beginning to wonder whether above-target inflation will become the new normal.

With the UK facing such risks, it should put further issuance of index-linked gilts on hold. Instead, it should issue a product far more friendly to the public pocket and in line with the government’s sustainable policy agenda: sustainability-linked bonds.

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There have been 70 sustainability-linked bonds issued so far, raising a total of $35bn, according to Capital Monitor sister company GlobalData. They are typically linked to emissions, but many corporates have linked them to other targets, such as the kinds of materials they use in production or the number of low-income households they serve. If issuers miss their target they suffer an interest rate step-up, raising their interest typically by 25–100 basis points.

Sustainability as a government strategy

The UK issued its first two green bonds this year, raising £16bn. A long-term sustainability-linked bond may be easier to scale up and offers more flexibility than green bonds.

Green bonds are ‘use of proceeds’ bonds: the issuer must tell investors what it plans to do with the money, and the projects the proceeds are invested in must be green and their performance usually measured and reported to investors. Sustainability-linked bonds are different. The use of proceeds need not be specified, so they are less dependent on projects and more on the ability to hit an overarching target.

As it did with its green bonds, the government should be able to tap into rising demand for sustainable investment products and issue sustainability-linked gilts at a lower interest rate than its normal gilts. The interest rate would then revert to a rate higher than on comparable normal gilts if sustainability targets are missed.

Index-linked gilts were introduced 40 years ago after a decade of double-digit inflation and at a time when inflation was top of the policy agenda. Following their introduction, inflation trended downwards, which tended to benefit the public purse. Now that this trend has gone somewhat into reverse, it is worth considering whether public debt issuance should start to reflect new policy realities. Sustainability-linked bonds may provide an answer.

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