UK defence bonds would be gilts dressed up under a different name, fixed income experts have warned, suggesting that rumours Treasury could issue sovereign defence bonds to plug a reported £15bn defence spending gap is not a viable option.
Former defence secretary turned chancellor John Healey has been pushing hard for increased defence spend, with the country committed to reaching 3% of GDP on defence by the next Parliament, driven by growing pressure from allies to share the burden of collective security.
Yet the backdrop remains challenging. Thirty-year gilt yields topped 6% last week for the first time since the late 1990s, driven by a combination of energy-driven inflation risk, expectations of further Bank of England tightening, heavy gilt supply and growing fiscal uncertainty ahead of the Budget on 28 October.
This leaves Healey with increasingly expensive borrowing costs as he prepares to set out his spending plans.
A sovereign defence bond would essentially ring-fence private capital specifically for military procurement in a way that would not breach the Labour government’s fiscal rules.
Yet the verdict from fixed income managers speaking to Trustnet is clear: defence bonds would cost more and offer no genuine diversification benefits. As such, they are unlikely to be viewed by bond markets as anything other than additional sovereign borrowing dressed up under a different label.
Learning from history
Defence bonds are not a new concept. The UK previously issued War Loans and War Bonds during both World Wars to raise capital from households and institutional investors.
Alex Harvey, senior portfolio manager and investment strategist at Momentum Global Investment Management, noted the War Loan issued in 1917 offered a coupon of 5% – which was ‘voluntarily’ reduced to 3.5% in 1932 – and was backed with “a patriotic fervour”.
However, the scale of funding required today to rebuild the UK’s defences “will need a multilateral approach with heavy buy in from institutions”, Harvey said.
And there is a much smaller pool of patriots to draw from this time around.
Lauren Mariano, fixed income portfolio manager at Robeco, said: “Today’s market is open and institutionally dominated, with overseas investors now the largest holder group at around a third of the market.”
This also isn’t the first time the UK government has tried to move spending off their balance sheets before.
Back in the 1990s, the Private Finance Initiative was introduced to enable the government to fund public infrastructure through private capital rather than direct borrowing, keeping the associated liabilities off the government’s books.
Harvey said: “But governments around the world are far more indebted as a percentage of GDP than they were in the 1990s – therefore, it is unlikely bond investors will be having the wool pulled over their eyes.
“That said, perpetual culprits like Argentina and Mexico have managed to issue debt on what appeared to be (and subsequently proved to be) overly favourable terms.”
The associated costs: Gilts vs defence bonds
Despite the political appeal of ring-fencing debt for a specific purpose, fixed income managers argue that defence bonds would offer little meaningful advantage over conventional gilts.
Emma Moriarty, portfolio manager at CG Asset Management, said: “Given the extent of scrutiny around the fiscal rules in recent years, bond market investors are unlikely to be fooled by attempts to raise additional debt through the back door.”
From a cost of capital perspective, Moriarty noted the implications are clear.
Gilt issuance attracts lower yields than other sterling denominated debt because it is centralised, managed efficiently and is raised against a very visible and public tax revenue stream, she explained.
“Defence bonds, should they be issued, will price at a positive spread over the gilt yield for the relevant maturity,” Moriarty said. “This means that they will be a more expensive form of debt for the government and, ultimately, for the UK taxpayer.”
Several factors will drive this spread, according to Moriarty. First, they will be smaller issue sizes than gilts, so will be less liquid. In addition, depending on how they are structured, they may not fit within the mandates of general government bond investors – “meaning that there is a question around whether markets treat them as a rates product or credit product”.
“Lastly, there are questions of structure, such as whether the government will guarantee the cashflows associated with the bond – this may narrow the spread to the gilt,” she added.
However, there is a place for defence themed bonds in the market, as these do already exist – for example, green and sustainability-linked sovereign issuance. The government’s green gilt programme, launched in 2021, raised billions of pounds for eligible environmental expenditure.
As such, James Scott-Hopkins, founder of EXE Capital Management, said “there is no fundamental reason why a comparable framework could not be developed for defence and national resilience”.
Who would buy them?
Beyond the question of cost, there is the equally important question of who would actually buy them. James Yardley, head of investment at Chelsea Financial Services, expects overall demand to be limited, noting that war and defence bonds would be a “terrible investment”.
“Investors who want exposure to UK defence would be better served by defence stocks, an area where the UK has real strength,” he said.
“There is no diversification benefit [to defence bonds] – they are a way for the government to borrow cheaply by appealing to patriotism, and the fact it is being considered speaks to the wider desperation of the UK’s fiscal position.”
However, others do see pockets of potential interest.
Moriarty suggested that multi-asset investors could benefit from UK defence bonds if the cashflows are government-backed, offering access to government credit at a higher yield than conventional gilts.
“But this represents an advantage that is closer to a spread arbitrage than a genuine portfolio diversifier,” she said.
Harvey reached the same conclusion from a different starting pointing, arguing defence bonds could be “selectively attractive” if investors demanded a risk premium for ring-fencing provisions, illiquidity or structural complexity, meaning “defence bonds could produce better expected returns than conventional gilts”.
However, that would be an enhanced income argument rather than a diversification argument, he noted.
“From a portfolio construction standpoint, we would struggle to justify an allocation based on diversification benefits alone. It would largely be another form of UK sovereign exposure.”
To capture institutional flows to fund its defence capabilities, Harvey suggested the government would likely try to “strongly encourage” domestic pension schemes to allocate a portion of their capital to this area. “The moral case for this will of course be highly subjective,” he said.
Yet Scott-Hopkins sees a path forward to attract the retail market – tying tax incentives to a National Defence Savings Bond “could encourage household participation, although the cost of any tax relief would need to be justified”, he said.
The government would also need to demonstrate that defence bond proceeds genuinely supported additional national security investment, Scott-Hopkins added.
“Investors should be able to see which projects are financed, how expenditure is monitored and whether the money supplements existing commitments rather than replacing them,” he said.
“The strongest case for defence bonds is therefore not financial engineering. It is an opportunity to link national savings to national security. Britain should not have to experience an attack before recognising the importance of protecting its infrastructure and strengthening its defences.”