Finance: The Government offloads its gilts

A further stage in the Government's economic management reform is implemented next month. The Bank of England's independence in setting interest rates has led, firstly, to it losing its responsibilities in regulating the banking sector, and, from next month, in managing the country's debt.

The Debt Management Office has been created to administer the Government's short- and long-term borrowing. It was felt the Bank of England could be accused of acting on insider knowledge if it continued to issue government bonds, setting their interest rates, while also deciding on overall interest- rate policy. The solution is to establish a new agency to manage the Government's cash flow.

Mike Williams, currently a deputy director at the Treasury in the finance regulation and industry division, is to be the DMO's first chief executive. Subject to official clearance, it will be an executive agency operating at arms-length from government, and has an office in Cheapside in the heart of the City. Some of the staff are on loan from the Treasury, others are on secondment from the Bank of England, with some recruited from other departments and elsewhere.

From day one the DMO will take day-to-day decisions on managing debt, within the framework of annual borrowing limits set down by Treasury ministers. But it will not take over Exchequer cash management before October, at the earliest. Part of its role will be to smooth the Exchequer's demand for cash during the year.

Issuing of government bonds, called gilts, will form a large part of the role of the DMO. Gilts are little understood outside of the Treasury and the City. The benefit of gilts is their security; while equities carry the risk of low dividends or even, ultimately, of being worthless if a company becomes insolvent, gilts are backed by the guarantee that the Government will meet its financial obligations. The inevitable downside is that gilt interest rates do not, usually, match equity dividends. This is particularly true during periods of high inflation, when the face value of the bond is being eroded.

Gilts are normally issued for between five- and 15-year terms, at the end of which they are redeemed by the Government. Interest, as determined by the initial terms, is paid annually. During their lifetimes gilts can be traded in a similar way to shares. Prices reflect both the outstanding period to maturity - the nearer the date of redemption the lower the value, as less interest is to be paid - and the interest rate paid on the bond. Some gilts are index-linked, which means that they will pay an interest rate at an agreed level above the rate of inflation. During periods of low inflation, gilts can offer competitive returns, and gain a higher retail price. Last year, for instance, a long-term gilt would have yielded a 19 per cent return, even after trading costs, compared with under 10 per cent for a unit trust.

Gilts, though, do not offer a secure long-term investment in periods of high inflation, as a new survey conducted by Barclays Capital confirms. Comparing equity, gilt and cash returns in Britain since 1918, Barclays found that high rates of inflation between 1954 and 1974 badly hit the real returns of equities, and produced negative returns on gilts. In the mid-50s, gilts produced a real loss of up to eight per cent. In 1991, however, when rates peaked, the real return was a positive 8.45 per cent.

The distinctive feature of Barclays' work is that it believes it can plot and predict real gilt returns according to demographic factors. It points out that future demographic trends are known, and that the technique could dramatically improve interest-rate prediction, not just for gilts, but across the whole economy.

A "life cycle theory of savings", examined by Barclays, assumes that working people save more as they get towards retirement age, and then use their savings during retirement. Personal indebtedness peaks when people are aged between 35 and 44, and reduces as people get older. This should create an increase in the supply of savings as our population gets older, bringing down bond, and dividend, yields.

Barclays' projections, based on this modelling, shows gilt yields "falling to levels not seen for 50 years", while "dividend yields on equities are projected to remain towards the low end of their range for the last 70 years". The analysts admit that explaining the past is not necessarily the same as predicting the future, and that economic relationships can change. But Barclays' approach does put it in conflict with some other economists, whose political analysis concludes the opposite.

Michael Taylor, senior economist at Lombard Street Research, says: "Gilt yields will rise this year because of inflation peaking by more than built into the market. Broad money is still growing at 10 per cent per year, and demand is still growing. The very strong domestic economy is going to push up wages, especially in the service sector. You are going to get wage increases feeding through, so inflation will be over three and a half per cent by the end of this year, and that will feed into a gilt yield of 7 per cent on a 10-year bond a year from now."

This Government has committed itself to reducing its borrowing, shifting expenditure away from interest payments to actual service delivery. The financial markets therefore expect to see a reduction in the amount of gilts issued in the next few years. This year the Bank of England was expected to issue pounds 37bn in new gilts, but pounds 20bn of this was to finance the redemption of maturing gilts.