Inheritance tax-exempt bonds can fill defence investment gap

Estimates of UK defence underinvestment up to 2030 fall in the range of £25bn-£30bn. That number will rise. The economy cannot bear further tax hikes, and this government has failed to deliver savings to welfare expenditure. We are left with raising debt to fund the shortfall. But how can we borrow more when we know we need to reduce our national debt? It was one thing leveraging the UK’s balance sheet when borrowing costs were at record lows, but long-term interest rates are now over 5% and potentially rising.

The chancellor’s focus on her fiscal rules is important. It reassures bond investors that the UK is a good credit bet. But why are we in this fraught situation when our debt to GDP is lower than many other countries whose borrowing costs are lower than ours? To understand this, we need to look at who holds our £3tn of gilts in issue. About 20% is held by the Bank of England and a further 20% by closed defined-benefit pension schemes. Both are net sellers of gilts (quantitative tightening and insurance buy-outs are the technical reasons). And a further 30%, close to £1tn, is held by overseas investors who set the marginal price for any gilt issuance.

That exposure has once again been brought into stark focus. The relative weakness of the UK’s balance sheet, combined with the structural formation of our government bond market, leaves us especially vulnerable to exogenous risks. The Middle East crisis and the concomitant surge in hydrocarbon prices (especially natural gas, to which we have a significant exposure) highlights our inadequate national resilience. Higher energy costs and the impact that will have on inflation and interest rates unsettles international investors and leads to hikes to our cost of borrowing.

Other nations have actively targeted domestic wholesale and retail buyers for their government bond issuance and have used fiscal incentives to do so. We do not have a state pension fund, unfortunately (that’s another story), but that would be a natural long-term buyer of gilts within a sensible strategic asset allocation. But what if we targeted domestic retail investors? They have the capacity to be big buyers if they are presented with the right incentive. British savers have more than £800bn in cash deposits and cash ISAs. Existing incentives exist (you can hold gilts in an ISA account, and gilts are free of capital gains tax) but this has not encouraged a significant rise in retail gilt ownership, which sits at about 4% of total gilts in issue.

If we want to access cheap, reliable, long-term (20 to 40 years) demand from new investors that will reduce our exposure to the volatility of short-term interest rates and dilute our dependency on international buyers, Rachel Reeves should issue defence bonds that are exempt from inheritance tax (IHT) for UK retail buyers. Issuing tranches of varied maturities would elicit strong demand, especially from those affected by the change to the IHT treatment of pensions. The government would be foregoing the potential receipt of IHT in the future, in exchange for a real and immediate reduction in its cost of debt. Developing this new market would also have a positive impact on existing gilt yields as traditional investors recognise the potential use of this new retail demand for other debt-raising and refinancing.

Rationally, an investor with a life-expectancy of 20 years should accept a return on defence bonds that was at least 2% less than the cost of the equivalent 20-year maturity gilt. It could be much more beneficial than this, though. The older the investor, the more attractive the IHT-free exemption and therefore the lower the coupon they would be willing to accept. This would determine the secondary market price, which would help the Debt Management Office to price new issues at lower coupons, further reducing the cost to the exchequer. Conservatively, demand should comfortably exceed £10bn in the first instalment and multiples of this in aggregate.

We need to increase defence expenditure significantly but we also need to make our national balance sheet more resilient. Tapping retail appetite by providing IHT-exempt defence bonds provides a scalable solution.

The question is whether the chancellor is prepared to put political ideology to one side in the long-term national interest.

Photograph by Richard Pohle/AFP via Getty Images