Humza Yousaf’s announcement that Scotland could issue bonds has prompted some interesting reactions. Financial columnist Matthew Lynn claimed in the Telegraph that such bonds would deal Scottish independence “a fatal blow… forever”. There are apparently not enough letters in the alphabet to cover how low Scotland’s credit rating would be. The Financial Times made comparisons with Venezuela and, as Lynn did, Argentina. Yousaf is presented as a modern-day successor to John Law, an 18th-century Scot whose monetary innovations in France ended in economic disaster.

This is all nonsense (both newspapers also carried far more balanced assessments). Scotland can issue bonds successfully, just as the City of Aberdeen did in 2016. The Scottish Government already borrows from the National Loans Fund (NLF), a UK government entity. It pays a margin over the UK’s own borrowing costs through issuing government bonds (‘gilts’, hence Scottish Government bonds being called ‘kilts’).

A Scottish bond would be priced in a similar way. Scotland’s borrowing is currently capped at £3 billion, very small relative to the size of Scotland’s economy and its government’s income. Repayment of a bond issue would not be a significant challenge for the Scottish Government. A bond issue might not be cost-effective compared to the NLF, but it can be easily completed.

The Scottish Government’s claims for a bond issue, however, also need scrutiny. It would “help raise Scotland’s profile and engagement with international investors to attract investment”, as Yousaf has suggested, albeit the benefit of this is small and not easily quantified. The larger claim that a bond issue would “demonstrate the credibility to international markets that we will need when we become an independent country” is more questionable.

A bond issue will obviously not be launched in the new Scottish pound that the SNP plans for independence, limiting any positive view investors would be taking. Conclusions beyond that depend on the details of any bond.

A devolved Scottish Government would be a sub-national issuer. Similar entities around the world commonly issue bonds. Nearly always, investors focus on the nature of support from the central government. We can be confident that the UK Government would not give a Scotland bond an explicit guarantee, a legally binding commitment to pay interest and repay the bond if the Scottish Government could not.

This would be the best form of support for investors but, in the UK context, an implicit guarantee is far more common. This is not a legal obligation to repay the bond issue, but the relationship between central government and sub-national issuer is such that investors can assume support would be provided.

The City of Aberdeen bond issue involves an implicit guarantee. Moody’s credit rating agency rates the bond one level below the rating of the UK Government, and far above the rating that Matthew Lynn illogically suggests is appropriate for Scotland. A crucial influence is “a high likelihood that the government of the United Kingdom [not, note, of Scotland] would intervene in the event of acute liquidity stress”. In other words, an implicit guarantee. As a result, investors in Aberdeen’s bonds are ultimately not expressing confidence in the creditworthiness of the City of Aberdeen, but in support from the UK Government, if that were needed.

There has been speculation that support would not be forthcoming for Scotland. This seems very unlikely. Economically, the cost to the UK of a Scottish default would be high, including damage to other UK sub-national borrowers from what would be a politically motivated unwillingness to ensure debt repayment.

Politically, refusal would also be inept. It would forego an opportunity to highlight the strength of the Union and risk a narrative similar to ‘Westminster supports Birmingham but not Scotland’. There may, of course, not even be opposing parties in Holyrood and Westminster at the time.

Moody’s thinks Aberdeen’s rating could be threatened by “a change in the relationship between Scotland and the UK”. There will be considerable focus on what a bond issue reveals about investors’ attitude to Scottish independence. Thanks to the implicit guarantee, the spread Scotland pays – the difference between the interest rates of Kilts and Gilts – will not reveal much, although unionists may well seek to exploit it.

However, other details of any bond would tell us more. The first is when a bond issue would be repaid. With the SNP’s current difficulties and the UK Government’s attitude, investors might well accept repayment further out than the time when independence looked possible soon. But generally, the shorter the maturity of the bond, the more investors are relying on the implicit guarantee and the less they are expressing confidence in an independent Scotland.

Nevertheless, in 2016, the City of Aberdeen borrowed until 2054, when independence arguably seemed more imminent. Investors might reasonably conclude that pretty much anything could occur regarding independence over the next few decades. This brings us to a second important detail.

Aberdeen’s bond includes what is called a ‘put option’, meaning investors can choose to be repaid early under certain circumstances. These are Scottish independence or if Aberdeen’s credit rating falls to three levels below that of the UK. It is hard to envisage changes in the relationship between the UK and Scotland short of independence that might result in such rating divergence, but the details of Aberdeen’s bonds represent belt and braces protection for investors against any undermining of the implicit guarantee.

If Scotland’s bond includes anything similar, it would demonstrate a very negative investor view of Scotland’s standalone creditworthiness.

Iain Hardie is an honorary fellow at the University of Edinburgh. He previously worked for 18 years in international bond markets.

Scottish Government bonds, aka 'kilts', may reveal much about investor confidence in an independent Scotland – Iain Hardie

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