Is Rachel Reeves trying to get us to buy up her debt?

New limits on cash ISA allowances will push higher volume savers into putting more cash into investment ISAs. The results might benefit the Chancellor. 

The debate over the changes to the cash ISA allowance were long-trailed and thoroughly unsurprising when they were announced in November last year.

From April, savers will see the amount of money they can shelter tax-free each year in cash ISAs cut from £20,000 to £12,000. 

The reality is that this cut to the limit isn’t going to affect Mrs Miggins’s monthly penny savers – no it will affect those who need to shelter larger amounts of money, probably most likely retirees cashing in pensions or downsizing houses.

But as has been widely discussed, there are a number of practical ways in which this allowance cut can be avoided. The Government made clear at the outset it would look to close these loopholes. The most obvious would be effectively banning the use of money market funds (MMFs) in stocks and shares ISAs. 

Even if it does this however, MMFs are just aggregated short-dated bonds and other similar instruments, managed for an investor by an intermediary. Investors, if they really want to, could just double down on the loophole by holding short-dated gilts directly, which are widely available to investors. This comes at a greater risk to the investor though. 

As I journey onto my own investment platform (AJ Bell where I hold my SIPP), I can currently buy a one-year UK gilt yielding 4.1-4.2% to maturity. This is more or less exactly the same as a current one-year cash ISA best buy from Investec, which is offering 4.12%. Funny that!

Both gilts and savings accounts have trade-offs and risks for the saver. The savings account quoted locks money up whereas the gilt can be sold off as and when in the secondary market. The gilt carries price risk and is trading at a very small premium at the moment. 

Additionally, platform fees and bid-offer spreads create more complexity for the saver and a reduction in overall earnings. But in a world where you’ve filled your annual £12k cash boots already, these trade-offs are probably acceptable to ensure you’re getting something ‘cash like’ if that is what you really need or want.

Recent reports suggest that cash interest earned inside investment ISAs, something now routinely offered by platforms, will be taxed at 22% despite being inside the wrapper. This further incentivises using a cash like alternative such as gilts. 

This begs the question – why should I be allowed to buy short-dated gilts but not MMFs? Is the Government therefore going to ban short-dated gilts from investment ISAs?

Banning short-dated gilts from investment ISAs would be a controversial and bizarre decision. It would create a sort of moral hazard where the Government says it is going to let institutions hold its (relatively safe) short debt but not private citizens. It would be a nonsensical stance. 

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What I actually think is happening is more interesting than that. While not necessarily a primary aim – I do think that these cash ISA reforms are helping the Government improve conditions for its own debt, albeit at the margins.

In other words – limiting cash ISAs will create more demand for cash like investments inside stocks and shares ISAs. If you’re also banning MMFs then savers really only have one option – buying Government paper. Boosting demand in this way is good for bond prices – and therefore lower yields, which currently are higher than comfortable for the Reeves et al. It also cuts out the middle men who might do something pesky like buying US T-bills. 

Indeed, just last week the UK Debt Management Office (DMO) announced it was going to start issuing more short-dated gilts by proportion. This is something which is much more common in the US and other countries but in the past the UK has shied away from.

Although longer-dated bonds are more expensive to service, they’re also less susceptible to issues such as refinancing volatility (rollover risk). When rates are low, locking in those rates for longer is a good idea. 

When rates are higher (our current situation) then issuing more short-dated paper is essentially a bet that rates will come down and thus lower borrowing costs in the near future. This is exactly why the UK is now shifting toward short-dated gilts. 

So where does this leave savers hungry for cash like investments? As said earlier, it inflates demand and thus further lowers the Government’s debt servicing costs. You’re just shifting capital off bank balance sheets and into the bond market.

Banks will find themselves with less deposits and therefore probably have to offer better rates to savers. But there’s a ceiling to this problem when most don’t hit the limit and those higher-volume savers have to shift capital elsewhere anyway because of the allowance itself.

In the most recent tax year for which we have data (2023-24), some £69.5 billion was contributed to cash ISAs. It is almost impossible to predict how much of that will be redirected as a result of the changes. It is likely incrementally useful for the Government rather than breathtaking.

Of course, there is risk in the Government’s short-gilt play too. If inflation spikes back up because of unforeseen circumstances (hello geopolitical risk) then the Government could find itself in a sudden fiscal bind at an awkward moment. So, you have to be confident the rate environment you’re operating in is in your favour. 

And if all these tweaks are only beneficial at the margins for the Government, the real loser at the end of the day is the saver who finds themselves subject to more complexity and risk when it comes to managing their cash savings plan. 

But good job we have advisers to help navigate that, eh?