The government of Scotland, one of the countries that constitutes the UK, has begun the process of selecting bookrunners and legal advisers for its first ever bond. Market participants are intrigued to know what the inaugural ‘Kilt’ issue will look like, where demand will come from, and what spread the note might pay.
The idea of Scotland issuing bonds bubbled up at the time of its independence referendum in 2014, when 55% of voters chose to stay in the UK. Some market participants nicknamed the possible bonds ‘Kilts’, in a play on the UK's Gilts.
In late 2023, Humza Yousaf, then Scottish first minister, announced official plans to develop a programme and issue by the end of 2026.
Market participants’ reactions varied at the time, debating whether the plan was genius or merely political theatre.
More than two years on, many outlines have become clear. Scotland has obtained credit ratings — to the surprise of some, flat to the UK’s at Aa3/AA. A £1.5bn borrowing programme over the next five year parliament has been announced, subject to the result of the Scottish parliamentary election on May 7 this year.
The inaugural issue is slated to come in late 2026 or early 2027. Many have interpreted this more narrowly to mean the last quarter of this year or first of next. The process to select bookrunners has also started.
These steps forward have raised market participants’ confidence that issuance will eventually materialise — something they doubted only a couple of years ago.
“It has been talked about since 2014 and there have been many conversations in the industry over the years, and it does feel like it’s going to go somewhere this time,” said Matthew Amis, investment director at Aberdeen Investments in Edinburgh.
“But we are still waiting to see the actual details of the deal when it comes — until then we're still kind of blind,” he added. “The credit ratings are a positive but obviously there's been the caveat of the independence [issue] to take note of.”
The leading party in Scottish politics, to which Yousaf and the current first minister John Swinney belong, is the Scottish National Party, whose ultimate aim is independence.
Despite the clarity that is emerging, market opinion is still split on whether Kilts are a good idea.
“I think it’s very exciting,” said a senior supranational, sovereign and agency bond banker in London. “There’s still a lot of time until the first deal comes of course, but it will be a very exciting deal to be working on. Bringing a new issuer to our market is always something we cherish.”
Others are sceptical. “These Scottish government bonds are a bit of a fudge,” said a UK-based fund manager. “Ultimately, Scotland is not fiscally independent from the UK, therefore it’s a halfway house between issuing their own bonds and it being just another Gilt.
“It would be a Scottish government bond in name only, and really a derivation of a Gilt. The key difference will be the illiquidity premium,” he added. “Fundamentally, the premium that Scotland will have to pay raises the question why they are paying any amount to issue. So it does look more political than economic, and a precursor for trying to achieve independence.”
Many have long questioned the sense of Scotland raising money from the market, since its bonds would probably have to pay a decent spread over Gilts — even if they have the same ratings.
But cost is not all that matters, said the supporters of the idea.
“Being able to raise money independently as an issuer and finding your own source of funds is a sensible thing from anyone’s perspective,” said the banker. “I think that would be the driver of them doing this.”
A second fund manager admitted there were “definitely two sides of the coin. Presumably, they think it's a good idea to borrow this way instead of the traditional way, so they must think they’ll be able to get value from it,” he said. “If it is managed well, it will be a tick in the box for John Swinney and his Scottish government.”
What will the deal look like?
Market participants are forming a picture of what the first deal could look like.
The issuance programme is limited to £1.5bn over five years, and Scotland has an annual borrowing limit of around £480m — based on a £450m annual limit set in 2016 which has been increased with inflation. Each Scottish bond will therefore will be more like the size of a corporate bond than a Gilt.
Considering the tenor, 10 years would be a natural choice for a government debut, but some think Scotland could — or should — go much longer.
One SSA syndicate banker thought 10 to 25 years was the possible range. “I’d expect them to be quite flexible,” he said. “It’s not necessarily a 10 year — in the sterling market there is a very decent long-end bid and given they want to fund for capital infrastructure, a longer bond would make sense.
“If [Scotland's] focus is on building a curve then a 10 year would make sense. But there’s time to find out what’s the most appealing part of the curve and where demand is greater.”
Amis said a longer dated bond would “be of a bit more interest” to him.
“As it’s their first, my assumption was they could come in 10 years,” he added. “But they can definitely take advantage of issuing longer, as the DMO [UK Debt Management Office] has reduced long-end issuance massively over the last year or so, to about 10% [of Gilt issuance] from 30% only five years ago and the curve has flattened.
“Ideally for us, it would be something that can sit in our Gilt portfolio, so we can hold that instead of a long Gilt, for the pick-up versus Gilts.”
The first fund manager, however, said that because of the deal's likely illiquidity, he would not expect a 10 year but “something shorter, maybe a five year”.
Many are not expecting much trading of Kilts, but for them to end up with buy-and-hold investors.
How to price it?
How to price a Scottish government bond is a conundrum.
Some SSA bankers had previously exclaimed that only “God knows” what Scotland’s spread should be. A broad range of pricing reference points across the SSA sector have been mentioned. This has also become much clearer with time.
The core comparables market participants told GlobalCapital they were looking at this week include Saltaire Finance, LCR Finance, and Jersey, Guernsey and the Isle of Man, which are not part of the UK but self-governing dependencies of the British crown. State-owned companies like Transport for London and Network Rail have also been floated.
Scotland “has the likelihood of extraordinary support from the UK government, but it’s not quite UK government-guaranteed, so it’s not going to be as tight as the government-guaranteed names like Saltaire or LCR Finance,” Amis said. “It probably would come somewhere between those and the likes of Jersey and Guernsey.”
Saltaire Finance, guaranteed by the Secretary of State for Levelling Up, Housing and Communities, has a £6bn MTN programme to finance loans to housing associations for decarbonisation upgrades of affordable housing.
LCR Finance has government-guaranteed bonds outstanding that financed the Channel Tunnel Rail Link.
The first fund manager thought the closest comp might be the Isle of Man. “The Isle of Man 2034 is trading around 5.25%, or about 75bp over Gilts, which is fairly chunky,” he flagged. “I would not expect Scotland to pay that much; probably it would be closer to 20bp-30bp over Gilts.”
A senior investment executive at a UK pension fund pointed to Guernsey and Jersey as the main comps, both at around 40bp over Gilts.
“On a standalone basis, Scotland is stronger, however there’s less chance of [Guernsey and Jersey] pulling away from the sovereign," he said. “Tenor will also make a difference, given spread should be less for the shorter tenor. Whether these will be eligible collateral at the Bank of England will be another determinant, but at these small issuance sizes, it may be less of a concern.”
The executive said he expected Scotland to develop a credit spread curve as it issued more bonds over the years.
“Personally, I think the sweet spot should be around 10 to 15 years,” he said. “I think there is limited risk above Gilts in owning 10 year Scotland, so if it came 30bp-40bp [back], that would attract buyers. If it’s inside 20bp — why bother?”
A bit of everything
In practice, the banks that get to price the inaugural bond will have to take into account “a bit of everything”, said the syndicate banker.
“Level-wise, the market will decide, but I’d expect to see [feedback] in a wide range. The building block will obviously be Gilts, but Scotland is a fairly unique animal — it’s neither a sovereign issuer nor a municipality. There’s also the context of how much they borrow from Westminster.”
Sterling bonds from sub-sovereign issuers outside the UK like Quebec and North Rhine-Westphalia will also be considered.
Then, there the spreads different sub-sovereign governments pay over their sovereigns in other currencies like euros, dollars or domestic markets.
At the tight end of the spectrum are French and Spanish regions, which are smaller issuers. Région Ile-de-France sold a 10 year deal earlier this month at 10bp over OATs and just this week, the Basque Government paid only 4bp over Bonos.
At the wider end of the range in Europe are the Belgian regions, which have paid nearly 40bp over OLOs this year. The German Länder’s spreads to Bunds are in the middle, about 25bp-30bp for five to 10 years and 35bp at 30 years.
Australian states are also wide versus their govvie, at about 55bp in 10 years.
For the Canadian provinces, GlobalCapital does not have access to authoritative data for the domestic market, but in US dollars, they pay around 15bp-16bp over the sovereign.
All the numbers aside, Scotland will benefit from “the novelty factor of the first trade”, which should drive demand, added the banker. “It’ll be a small size, but it’ll pass for a benchmark size. Obviously, the relative value will come into play, but I think it’ll be a unique deal that most people will want to be involved in.”
What kind of issuer?
Pricing aside, the market has yet to agree on how to classify Scottish bonds.
A senior public sector debt capital markets banker in London said that “instinctively”, Scotland should be considered a government issuer.
“It’s not quite government in the classic or the purest sense, or for index or rating purposes,” he added. “But a government is probably the nearest thing — they are a government. But probably people would say they are somewhere between a government and a sub-sovereign.”
He thought Scotland’s investor base could overlap with that of UK local authorities, a handful of which have issued bonds, including the City of London and Aberdeen City Council. “There’s a whole range of them, but we’re probably looking at 40bp over [Gilts],” he added.
But the banker warned: “In that size and that currency, there are some restrictions that you can’t overcome, even with a lot of novelty — you can’t overcome the fact that there are not a lot of [typical SSA investors] that can buy [into a bond as small as] £300m.”
Amis said Aberdeen Investments had yet to decide where Scottish bonds would sit in its funds. “We run both Gilt and SSA funds, and we’ll wait to see how it’s classified, but from my perspective, we see this probably somewhere in between — there’s not much out there like Scotland,” he said.
The big risk
The elephant in the room is the risk of Scottish independence. S&P, while rating Scotland the same as the UK at AA, acknowledges this.
“The reason we rate Scotland at the same level as the UK sovereign is that we believe Scotland benefits from the strong fundamentals within the current institutional framework for devolved regions within the UK,” said Natalia Legeeva, credit analyst at S&P in London.
Were it to leave the UK, Scotland would lose those benefits. There are well agreed funding arrangements under which the UK makes substantial grants to Scotland, covering around 60% of its revenue, Legeeva explained.
There is also a “very strong level of oversight” from the UK government. Scotland is obliged to balance its operating budget and has a borrowing limit and debt ceiling set by the UK government.
Legeeva said that independence was not part of S&P’s base case scenario. “We view the likelihood of it as pretty low,” Legeeva said. “But it is still a downside risk, and if we see any material steps towards that, it would be a trigger for us to review whether we would take any rating actions, as it might disrupt the existing beneficial agreements between Scotland and UK government, and in that case it is likely that we won’t see it at the same level as the UK government.
“Admittedly, it is difficult to incorporate the probability of what may happen and how it will look like at this point in time.”
The fund manager said he expected that if Scotland became independent it would have a “much lower” rating. “It would be subject to negotiations between Scotland and the rest of the UK, and include questions such as how the existing Gilt stock is divided up, what would happen with the nuclear deterrent and North Sea oil, and so on,” he said.
Amis admitted that independence risk was something investors would have to take into account. The longer the bond was, the higher the “independence premium” would be.
“If it was 25 to 30 years to take advantage of the curve shape," he said, "then you have to build in more of that independence risk — which doesn’t feel very high at the moment — but a lot can happen in 30 years.”
