Scottish Bonds

What Kilts Might Reveal: A Discussion of Scottish Government Bonds Part 2

Published: 4 December 2023

What Can be Learned About Independence?

Humza Yousaf has claimed that a Scottish bond issue would ‘demonstrate the credibility to international markets that we will need when we become an independent country’. This is questionable for several reasons. The importance of the implicit guarantee has already been discussed in Part 1. Most importantly, independent governments in countries similar to Scotland rely overwhelmingly on borrowing in their own currency. The SNP’s current plans are for a new Scottish pound, so the credibility Scotland will need will be for borrowing in this new currency. This cannot be demonstrated ahead of independence, for obvious reasons. The credibility demonstrated by the planned bond issue will therefore be limited. There will be information to be learned regarding investors’ attitude to Scottish independence, but this will depend on the details of the bond issue.

For any borrowing by a devolved Scottish government, there is always an elephant in the room. Moody’s highlights a threat to Aberdeen’s rating from ‘a change in the relationship between Scotland and the UK’. A UK government implicit guarantee would not outlive Scottish independence, at least in its existing form. The same is true for a Scottish bond issue. Some form of international bailout of a bankrupt independent Scotland might happen – the UK contributed to Ireland’s bailout in 2010 – but the possibility of some form of external support exists for all sovereigns, and its nature and timing is too uncertain to influence currently-perceived creditworthiness.

It is impossible to say in advance how much this might matter, with major influences being how long any bond issue would be outstanding and the political situation at the time of issuance. A 3-year or even longer bond issued now, with the SNP’s difficulties and Westminster intransigence, might receive a very different reaction in this regard to a 20-year bond issued when the SNP is riding high and opinion polls show a clear majority for independence. Nevertheless, the implications of independence for any bond’s creditworthiness will almost certainly be a major preoccupation for investors.

It certainly was in the case of the City of Aberdeen bond. Investors required a put option – the right but not the obligation to be repaid early – in the event of Scottish independence. In 2016, the market would not take the risk of Aberdeen relying on an independent Scotland rather than the UK providing an implicit guarantee. The Aberdeen bond is not repaid until 2054, so investor caution could also be linked to a view that pretty much anything could occur regarding independence over the next several decades. It could be argued that investors valuing this put option are taking a positive view on the process of independence, if not independence itself. They are after all confident that Aberdeen would be able to repay the £370 million bond at a time presumably of considerable uncertainty. Aberdeen’s bond was nevertheless not a vote of confidence in an independent Scotland. A similar put option in a Scottish government bond would be something unionists could reasonably exploit as a meaningful indication of negative investor perceptions regarding independence.

It may be possible for the Scottish government to finesse a need for this put option. Investors in Aberdeen’s bond could also demand repayment if Aberdeen’s rating fell to three or more levels below that of the UK. If the UK remains rated Aa3 rated, a fall to A3 (still comfortably an investment grade rating) or below would be sufficient. With Aberdeen’s – and in future Scotland’s – rating underpinned by the implicit guarantee from the UK government, it is hard to see an event other than independence that might trigger such an increased rating divergence.

This is, however, protection for investors against changes short of independence, such as dramatically increased fiscal autonomy for Scotland, that might undermine confidence in the UK’s implicit guarantee. Scotland may be able to include only the rating divergence put option. Nationalists could then argue that the economic arguments in favour of independence include that an independent Scotland would not be rated a lot lower than the UK. Unionists would doubtless respond that the rating would be much lower, but also that regardless the divergence put option demonstrates international investor concern about the viability of an independent Scotland.

The unionist argument here cannot reasonably be pushed too far, and a ratings-induced put would not be such a negative sign of investors’ view of an independent Scotland. Investors are always concerned with even a small fall in ratings, so requiring this put option would not be a message that an independent Scotland is unviable. Nevertheless, it would be a negative signal, and rare on similar bond issues, albeit one that may be difficult for unionists to exploit fully.

The details of a Scottish bond will therefore convey some limited information about investor attitudes to future Scottish independence. Once the bond is issued, there is also the possibility of information from the level at which the bonds trade in the secondary market, especially the spread relative to similar issuers, although once again this is somewhat technical. It is important to note that the bonds will not be very liquid, at least until there are far greater volumes of issuance, so any conclusions from market movements should be cautious. Precisely what can be learned will also be related to the details of the issue.

If Scotland issues a bond without any of the put options discussed above, then the relative trading performance – ignoring overall market conditions – will be driven by investors’ assessment of a combination of the likelihood of independence and the consequences for creditworthiness of independence. This can be represented by a simplistic probabilistic calculation. If Scotland becomes independent, an investor thinks these bonds will trade at, say, 90 percent, if it does not become independent – and therefore the bonds retain their implicit guarantee – the investor thinks the bonds will trade at a price of 100 percent. She thinks the probability of independence, judging by opinion polls etc., is 40 percent. The bonds are therefore worth (90 x 0.4) + (100 x 0.6) = 96 percent. (The same calculation could obviously be done using the spread over Gilts.) If the bonds are currently trading below 96 percent at the time, they are worth buying, if above 96 percent they should be sold.

Nationalists may be able to influence the assumed value of the bonds in the event of independence, with for example clear plans that meet investor approval, but the likelihood is that investor perceptions of the creditworthiness of an independent Scotland are quite fixed. As a result, the bigger influence will be changing expectations of independence taking place, which are in turn driven by highly visible opinion polls and more subjective assessments of the overall political situation. This, of course, would not stop unionists pointing to falling bond prices or rising spreads as evidence for investor fears of the consequences of independence for Scotland’s ability to repay its bonds.

If the bonds contain one or both of the put options discussed above, investors who fear the impact of independence have some protection. If independence becomes much more likely, the bonds may trade as if the put at independence is inevitable, obscuring any message from the performance of the bonds. If interest rates fall after issuance, the price of the bond could be pushed up to the extent that exercising a put option to sell the bonds back to the issuer at 100 percent may represent a substantial loss for the investor, rendering the option largely valueless. There will be ways of construing the market’s message regardless, but the complexity of these methods means any political impact seems unlikely.

 

Iain Hardie is an honorary fellow at the University of Edinburgh. He is an expert on political economy, with a particular focus on financial globalization, financial markets and government bond markets. He entered academia following a long career in investment banking in London and Hong Kong, specialising in emerging bond markets.

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