Kilt trip: Why Scotland is preparing to issue bonds

It was during his one and only conference address as SNP leader that Humza Yousaf announced the Scottish Government would begin issuing bonds. Overshadowed by an unlikely council tax freeze, a rabbit in the hat seemingly inserted into the speech at the last minute, the news of this new form of government borrowing gained precious little coverage at the time other than the odd withering editorial drawing comparisons between Scotland and Venezuela. 

“I can confirm that by the end of this parliament the SNP government will – subject of course to due diligence and market testing – go directly to the international bond market for the first time in our own right,” Yousaf told party members. He said the money raised would be used to fund “vital infrastructure” such as affordable housing projects, while also building “credibility” with international markets ahead of Scotland one day becoming an independent country. 

Bonds are a financial instrument where the issuer promises to repay the stated amount after a given period alongside annual interest payments. UK Government bonds, known as gilts (so-called because they were historically edged in gold), are the main mechanism used to borrow by the Treasury, with the national debt currently around £2.9tn or roughly 96 per cent of GDP. 

Scotland’s borrowing will be far more modest – the current plan is for a £1.5bn bond programme during the next parliament, with the securities somewhat predictably already being referred to as ‘kilts’. 

As a result of the 2012 Scotland Act, the government in Edinburgh was given increased powers to borrow for capital investment from the UK Government’s National Loans Fund (NLF). Under the Tory / Lib Dem coalition government and Chief Secretary to the Treasury Danny Alexander, the Scottish Government was then handed the power to issue its own bonds in early 2014 – the same year as the independence referendum. While Alexander called the move “historic” at the time, the SNP sought to play it down, with then leader Alex Salmond saying it was “hardly huge news”. 

But the SNP’s position has changed in the years since, with First Minister John Swinney describing the bonds issuance as a reflection of the “maturity of Scotland’s public finances after more than 25 years of devolution” and the latest step in building the institutions needed for a country that “takes responsibility for its own decisions”. In an outline business case published late last year, the government said changes introduced under the 2023 Fiscal Framework Agreement had created opportunities for it to diversify its sources of borrowing and structure debt in a more cost-effective manner.

“A bond programme could enhance Scotland’s visibility and credibility with investors,” the business case said. “Sovereign and sub-sovereign credit ratings serve as trusted indicators of financial stability and risk, acting as an economic barometer and a source of information for investors. Participation in international capital markets and a credit rating could play an important role in reaching relatively uninformed investors, potentially expanding the investor base in Scotland.” 

There’s nothing new about countries, states, provinces and even local councils issuing bonds. All 16 of Germany’s federal states – some of which have economies a similar size to Scotland’s – issue bonds. In the United States, municipal bonds or ‘munis’ are used to fund major infrastructure projects, with California, the world’s fourth-largest economy, the biggest issuer. Closer to home, Aberdeen has borrowed using bonds, becoming the first Scottish city to do so when it issued securities totalling £370m in 2016.

Nick Chatters, a senior portfolio manager at the investment firm Aberdeen, says Scottish Government bonds are likely to be bought up and locked away by pension schemes and insurers as an alternative to UK gilts, with the liquidity (the ease with which they can be bought and sold) likely to be quite low. He says bonds make sense if the yield (the annual return paid to investors) is lower than the interest paid to borrow from the UK Government via the National Loans Fund. 

The headquarters of the Bank of Scotland, once Scotland's national bank, on the Mound | Alamy

“Scottish issuance will highlight the country’s profile and credibility as an issuer,” he says, “but the question is whether it’s going to be cost-effective. Scotland currently borrows money through the fiscal framework agreement with the UK. Is it cheaper to do that via Scotland issuing its own sovereign bonds, i.e. will the yield on those be lower than borrowing through the fiscal framework? The Scottish Government clearly has a view that it will be otherwise they wouldn’t be going down this route.”

Swinney was in London yesterday where he announced the procurement for book runners (the banks which will manage the issuance) and legal advisers will go live this week. Announcing the planned issuance in November, the first minister made much of the fact Scotland was awarded the same credit rating as the UK and above major economies such as Spain and Japan. He said this was “testament to Scotland’s strong institutions, track record of responsible fiscal management and pro-business environment”.

But Moody’s, one of the ratings agencies responsible for that assessment, said its determination was based on Scotland’s place within the devolution framework and the “very high likelihood of extraordinary support from the UK Government”. The agency went on to note that Scotland’s ageing population would cause fiscal pressures in future due to the government’s reliance on income tax receipts. And it said Scottish independence “could exert downward pressure on the rating by introducing heightened uncertainty about the institutional framework and potentially raising financial stability risks”.

“The market thinks that Scotland, as part of the UK, will have an explicit guarantee,” says Chatters. “That’s not been agreed, that’s not been announced – it’s an assumption. There’s a big supra sub-sovereign market in the Eurozone where some of the bonds have implicit or explicit guarantees. I think the market assumes that from Scotland’s perspective there will be a guarantee that’s strong enough to put the credit rating in line with the UK.”

The need for the government to find extra funding for capital projects was underlined by this month’s budget, where finance secretary Shona Robison set out her tax and spending plans. In advance of the statement, the University of Strathclyde’s Fraser of Allander Institute warned of a £1bn black hole in the capital budget and called on the government to explain which projects are to be prioritised and which will no longer go ahead. It later said that a revision downwards to the tune of £850m showed the government knew its “original plans were unaffordable”. 

When it comes to day-to-day spending, the largest part of Scotland’s budget is made up of the block grant from the UK Government, which includes money allocated under the Barnett formula, the mechanism first devised in 1978 by which Scotland is allocated its share of comparable government spending in England. According to the Treasury, the Scottish Government receives at least 20 per cent more per person than equivalent government spending in the rest of the UK.

Savvas Savouri, managing partner at QuantMetriks, an economics advisory firm, says the issuing of Scottish bonds backed by the UK Government could lead to a re-evaluation of the Barnett formula.

“It’s a quid pro quo,” he says. “If Scotland wants to issue gilts that are underwritten by the Exchequer then the block grant and the Barnett formula has to be re-written because it was devised five decades ago. If you’re Scotland, do you really want to lose that premium per capita over the rest of the country in how revenues are allocated? 

“If you want to issue your own sovereign debt – kilts – there should be an understanding you raise taxes at the sovereign level, so you have Scottish, tartan taxes. The more you raise in Scotland… some of the (UK) taxes reduce, which reduces central government receipts. So why should English and Welsh taxpayers still send money to Scotland? It doesn’t quite add up. At some point [the Barnett formula] has to go.”

And he says a vote to leave the UK, should it happen, would likely lead to higher bonds yields as their value falls, which could ultimately cause a reassessment of the country’s credit rating.

“While Scotland is part of the union, it’s not self-financing. If you go across the Rubicon and Scotland becomes independent, it has to be self-financing either through taxation or issuing debt. A rudimentary analysis of Scottish fiscal and monetary positions is that Scotland would be forever issuing debt because its tax receipts are lower than its spending.

“Without the Barnett formula, Scotland’s per capita taxation and per capita debt issuance would be higher than England. The [bond] yield would change dramatically and that would trigger a de-rating. Very few countries default [on their debt] but what would happen is that there would be austerity.” 

Former US president Bill Clinton’s chief strategist James Carville once famously said that if reincarnation existed, he wanted to come back as the bond market. Its power was demonstrated by its killing off of the political careers of former prime minister Liz Truss and her chancellor Kwasi Kwarteng following the disastrous “mini” Budget in 2022, which is said to have cost the Treasury £30bn. And Rachel Reeves was given a reminder of the market’s power to shape political careers when government borrowing costs spiked in the run-up to the Autumn Statement after she ditched a widely touted plan to put up income tax.

At the level of borrowing currently proposed, the Scottish Government doesn’t have to worry about the wrath of the bond market just yet. 

“It’s going to be tiny,” says Chatters. “It’s the sort of thing an insurance company or pension scheme would look at and just lock it away and never be traded. I don’t think it will be big enough to provide market liquidity.”

Savouri says Scottish bonds will get snapped up but takes issue with the Scottish Government’s argument that issuing them will help raise the country’s profile on international markets, an argument he says is “vacuous”. 

“Local councils issue bonds internationally. I don’t think investors in Singapore have been awakened that Westminster or Fulham or Bromley is a place to go visit [because of that]. If you call it a ‘kilt’ it masquerades as something it isn’t – something unique, but they’re not inventing anything new.”