Bill Jamieson: Uncertainty over new ‘kilts’ market

The FT reported last week that global agencies have yet to issue Scotland a credit rating. Picture: TSPL
The FT reported last week that global agencies have yet to issue Scotland a credit rating. Picture: TSPL
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Rumbles in the bond market, sharp rises in bond yields, and fears the long-predicted bursting of the bond market bubble may be at hand: hardly the best backcloth for Scottish government bonds – not gilts, but ‘Kilts’ as they are already nicknamed.

With greater borrowing powers already in place and the prospect of more to come in forthcoming negotiations over the Smith Commission proposals, Scotland may soon be in the global bond market.

So how big might the Scottish ‘Kilt’ market be? Who would regulate it and what might the rate of interest be? And would the ‘Kilts’ raise funds at a lower rate than, say, those from the Public Works Loan Board, managed by the UK Debt Office?

These are hardly the sexiest questions in the clamour about “more powers”. But, as with so much in politics, the devil is in the detail. And bond market borrowing is one of a large swathe of details to be hammered out over the next two years.

The Scottish government has fought for the right to access capital markets directly rather than remain under Westminster borrowing constraints. However, short of attaining full independence, the Treasury through the UK Debt Management Office will continue to set overall limits on how much a Scottish government would be allowed to borrow.

Little has emerged about this aspect of “full fiscal responsibility”. But it will be a critical component of future Scottish government spending and revenue plans and will influence Holyrood’s spending ambitions.

Since April, Scotland has been able to borrow up to £2.2 billion, although the UK Treasury has indicated that Scottish government borrowing should not exceed 10 per cent of its capital budget. This would give a limit of £304 million for the current financial year 2015-16.

The FT reported last week that global agencies have yet to issue Scotland a credit rating. This is a typical precursor to a bond debut but it is difficult to see how such a rating can be arrived at until more detail is available, not only on the likely size of the Scottish budget and its tax and spending plans but also on how much leeway it will have on the revenue raising side.

What security would a Scottish administration with more devolved powers be able to offer? Any bonds it sells to the market would not be underpinned by a UK government guarantee. So what might be the risk premium that would attach to “Kilts”? Responses to a Treasury consultation last year suggested Scottish bonds would be priced in relation to the UK gilts market, with Scotland’s borrowing costs anywhere between 35 to 130 basis points above the UK’s.

The confidence about access to low cost bond finance last year has faded somewhat. During the referendum campaign the Scottish government was able to point to buoyant revenues from North Sea oil – Scotland’s biggest export – as a reassurance for prospective lenders. But the oil price slump in the final quarter slashed projected tax revenues. And while the oil price has partially recovered, the current $66 a barrel is way below the $110 a barrel base price the SNP administration had been forecasting.

In addition the pace of economic growth has slackened and the shake-out from the offshore sector has contributed to the recent rise in unemployment in Scotland – in direct contrast to the UK as a whole where unemployment has continued to fall.

The administration does not face any immediate shortage of loan capital. It can borrow from the banks, from National Loans Fund or raise money through asset sales.

However, looking to the medium term there are reasons to doubt whether current ultra-low government bond yields will persist. The past few weeks have seen tremors across government bond markets as investors have grown nervous over the sustainability of the 30 year bull market in bonds and whether a major correction may soon be at hand. This recent instability in bond markets has pushed yields up – and prices lower.

These fears may be overdone in the immediate term. I had the pleasure last week of meeting Bill O’Neill, head of the UK investment office at UBS Wealth Management and Colin Aitken, executive director in Scotland. Bill believes recent market volatility will abate soon. Considerable slack remains in the European economy, inflation is not likely to prevent the ECB from remaining accommodative and there is little likelihood of any early rise in interest rates.

However, a rise in UK interest rates still looks on the cards. The worry is this may coincide with a maturing of the recovery cycle that has now been in force for six years. It’s not impossible to see in 2017 Scottish government bonds making their debut with a troubling convergence of rising interest rates – and economic slowdown.

Patriotism will sustain interest in Scottish government bonds. But there are many details to be thrashed out – and investors will reserve judgement until they can see all the fine print.