In order to understand the results of this process it is useful to re-examine how QE works. Simply, QE is the willing exchange of gilts for cash between the Bank of England and the private sector. Both gilts and cash are denominated in the same common currency, the main difference to the investor is that gilts pay a coupon, usually until a specified maturity date when they change to cash on a one-for-one basis. Cash on the other hand has a zero return, unlike a gilt, and exists in perpetuity. Both cash and gilts can be lent to a third party in return for a payment. But that payment is simply a transfer payment for borrowing the asset (cash or gilt) with no extra intrinsic return being embedded in the cash or the gilt.
Therefore as an investor you have the choice of owning a gilt that pays you extra return until a set date when it turns into a cash security that pays you no return forever, or investing straight away in cash that pays you no return forever.
Holding gilts looks intrinsically superior. A buy-to-hold investor of a gilt with a positive yield will always end up with a higher cash balance than the investor holding cash. Why do investors therefore choose cash over gilts? Mainly, it is due to the fact that the price of a gilt can go up or down, while the price of cash never varies. This risk-aversion means investors are willing to forego a positive return in order for certainty when they decide to hold cash.
From an issuer’s perspective this is wonderful and can be taken advantage of. If the Government can exchange interest-bearing securities for cash (QE) then they can swap interest-bearing securities that need refinancing at maturity for non-interest bearing securities that never need refinancing.
If for example 25 per cent of the national debt has been exchanged for zero-coupon perpetual securities (cash), then an 80 per cent debt-to-GDP ratio effectively gets transformed into a 60 per cent debt-to-GDP ratio, as 20 per cent costs nothing to finance, never has to be repaid, and so is therefore effectively free finance.
The more of your outstanding debt you can finance at zero-cost forever, the more debt you can sustain. If this free financing is undertaken responsibly it can be used as a sensible economic tool. However, if the temptation of free finance results in a misallocation of resources via the state, then it can be very harmful to the economy. This is why many economies have introduced the concept of an independent central bank to remove some of the political process from the real economy.
So far, the Bank of England has convinced the market that QE is a responsible policy. The use of QE has neutered the bond vigilantes, while the next enemy of this policy, the currency vigilantes, remain dormant.
The Bank could officially cancel the gilts or could simply exchange its existing gilts at maturity for new gilts to maintain the windfall gain of free finance. This topsy-turvy world of money printing, low bond yields and free financing is a new challenge for investors.
Richard Woolnough is manager of the M&G Optimal Income and M&G Corporate Bond funds. The views expressed here are his own.