Fool's Eye View

[ September 21, 2000 ]

Government Buyback

By Rob Davies (TMFEssex)

Carburton St, London -- A fundamental tenet of the Foolish approach to managing finances is the imperative of reducing debt. Well, it seems that this approach has found favour in wider circles than we thought. Despite his current problems with fuel taxation Gordon Brown, the Chancellor of the Exchequer, has actually got money flowing in to the coffers at a rate of knots. And this is good news for all investors, as I'll explain.

Yesterday he received a cheque for £10b from the telephone companies as their second payment for the third generation mobile phone licences. That takes total government debt down to £320b. Now that might sound a lot, but it is only twice the market capitalisation of Vodafone (LSE: VOD). In the overall scheme of things it really isn't very much at all. This is the National Debt we are talking about, the total liabilities of Her Majesty's Government that owns so much of the stuff we see around us; like police cars.

That all sounds jolly fine, but what has that got to do with the Foolish investor. Well, a lot actually. Last night my sagacious colleague TMF Jimmy C, in his Fool's Eye View, looked at the speculation surrounding the Bank of England's interest rate decisions. He concluded that the market should be much more interested in the bigger picture, and he is right. You see, not only is the Government getting money in from phone licences, it is also receiving more in tax than it is spending on services so it has positive cash flow and is repaying even more debt. In other words, not only is government debt low, it is getting smaller.

Bonds are getting rarer

Governments don't borrow from banks, they borrow using bonds. Government bonds are called gilts in the UK. They are sold to investors and pay a fixed amount of interest. Now if the government is buying these bonds back, other things being equal, prices should go up. In a way it is a bit like a company buying back shares; that normally pushes the share price up. Of course bonds are not shares, but the effect of a higher bond market is to reduce the income you get from holding them. So, just as dividend yields fall as share prices rise, interest rates fall as bonds rise.

Perhaps an example would help. Gilts have a nominal value of £100 and the interest is expressed as a coupon, say 6%. That means for every nominal £100 you invest you get £6.00 of interest. But today those bonds actually change hands at £119, so the rate of interest is only 5.0%. These particular bonds don't expire until 2028, so that means if you buy them today you can guarantee an income of 5.0% for the next 28 years. Mmm, that sounds quite appealing. It isn't quite the whole story, because when they finally mature the Government only gives you back the £100 rather than the £119 you paid, so the actual yield if you held them to maturity, called the redemption yield, is only 4.7% -- before inflation -- and that is not quite so good. Nevertheless, there is one group of investors that really, really like gilts, and that is just as well because the Government virtually forces them to buy them. That group is the pension funds.

It is true that pension funds mostly hold equities, but once the scheme members retire the funds like to buy gilts because they want to ensure that they can generate enough income from investments to pay the pensions. The best way of doing that is for them to buy gilts, and a little thing called the MFR (Minimum Funding Requirement), which we won't go into now. Suffice it to say that pension funds manage something like £900b of funds and most of that money belongs to the 10.7m that are still working and contributing. But as they age, and join the 7m that are already retired, the demand from the pension funds to buy gilts can only increase.

Moreover, that £900b is going to grow as more people save for retirement and as that money generates good returns from the market. Hang on though; the gilt market is only worth £320b. How is another chunk of that £900b of pension fund money going to find a way into gilts at the same time as the Government is shrinking the gilt market by its sensible policies?

Something has got to give. To my simple mind, that must mean that gilt prices will rise and hence long term interest rates will fall. That 4.7% guaranteed return from Treasury 6% 2028 might actually start to look very juicy if the gilt market goes up much more.

But what's all this got to do with investing? Actually, quite a lot, for two reasons. Long-term interest rates are usually used as the discount rate to assess the present value of a company's future earnings. A lower discount rate means that the future earnings of companies are worth more and that raises the value of companies. That is the most powerful positive effect working on the market. But there are other factors too.

If pension funds can't buy enough gilts to get the income they need to pay pensioners they will turn to high yielding shares to make up the difference, and that has got to be good news for high dividend payers like utility shares. Basically, then, the Government's debt reduction programme is extremely good news for investors all round. The only fly in this most efficacious of ointments is that long-term returns from investments are probably going to fall. But that's another story.

Where Next?

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