Weathering the stormy gilt market

It’s proving a pretty grim start to 2025 for those charged with managing UK government finances as the country’s borrowing costs spike to their highest levels in years. Last week, the 10-year gilt yield jumped above 4.80% for the first time since the 2000s, when the global financial crisis struck, and it’s currently hovering at around 4.90%. The 30-year gilt is trading above an eye-watering 5.50% – it last hit that level back in 1998. 

Government bond yields are generally expected to be the steadiest Eddies of all investments. But the yields on UK, US and many Eurozone government bonds (which rise as their prices fall) have been very far from steady for several months. 

They’ve been popping higher even as central banks have been cutting overnight interest rates. These rates are the key driver of shorter-term borrowing costs, yet they can have much less impact on the yields and prices of longer-dated government debt. These tend to be influenced more by what investors think will happen to economic growth and inflation further into the future. Government spending and debt issuance plans also matter at the long end of the yield curve because of the simple matter of supply and demand: if more bonds are supplied than people want, their prices will fall and their yields will rise! 

No more blank cheques?

Overall, it seems that the spike in government bond yields is the result of increasing investor twitchiness about the huge amounts that many governments are borrowing and their ever-widening fiscal deficits (the gaps between what they spend and the revenues they get from taxes). That makes them nervous that inflation will remain higher, preventing central bankers from reducing their overnight rates as much as forecast. 

Most major developed countries have struggled to rein in these deficits, especially since the pandemic. For a long while, big investors in government bonds haven’t worried too much about countries piling up their borrowing. But that now seems to be changing as concerns grow that it could result in too much debt supply for bond markets to absorb. Investors are demanding extra compensation (via higher yields) when lending to governments that keep issuing more and more debt. 

As a global sell-off in longer-dated government debt has gathered pace in the last few weeks, gilts are caught in the eye of the storm. 

The UK can be particularly vulnerable to global market moves because international investors tend to own a larger share of UK government debt than in a lot of other big economies. US Treasury yields have been grinding higher ever since Donald Trump’s November election victory because investors fear his planned tax cuts, higher trade tariffs and restricted immigration could add up to higher US inflation and interest rates. The US 10-year Treasury yield is currently above 4.75%, its highest level since October 2023. When Treasuries sell off, gilts can sell off more sharply than in some other government bond markets. 

The Budget effect…

Concerns over the domestic economic outlook have also been key in stoking gilt market woes. Ever since the Labour government unveiled its first Budget on 30 October, investors have fretted about its plans to borrow an extra £30 billion per year over the next five years. That means UK government debt issuance is set to reach its second-highest level on record this fiscal year. As well as worrying about a glut in gilt supply, investors are increasingly nervy about how the UK economy will hold up following the big taxes rises that were also announced. Labour plans to hike taxes by around £40 billion per year (mostly by increasing Employer National Insurance Contributions (NICs) and halving the threshold at which they kick in). 

Businesses have warned that these extra NICs costs must be absorbed through some combination of higher prices, reduced profits, lower wage increases or lower employment. All this seems to have put the brakes on UK economic growth. In mid-December, the Bank of England (BoE) announced that the economy was doing worse than it had expected and probably didn’t grow at all in the fourth quarter of last year. It’s also warned that it expects the Budget to stoke inflationary pressures through things like the big increase in the national living wage from April. It already seems to have resulted in price rises as firms pre-emptively pass on their extra NICs costs to shoppers. Fears of resurgent inflation have led investors to conclude that the BoE will probably cut rates less and more slowly this year than they’d previously expected, exacerbating the upward pressures on gilt yields.

All this has created a nasty doom loop. As investors have got more worried about the UK economic outlook, they’ve concluded that a struggling UK economy will hit government revenues and so worsen the fiscal backdrop. That’s led some to fear that the government might be forced to further increase its borrowing and, in turn, that’s meant big gilt investors have demanded higher gilt yields to compensate them for these concerns. 

When investors are jumpy, big gilt sales can have an outsized impact on confidence throughout the market as a whole. It seems likely that last week’s sharp spikes in gilt yields could have been triggered by investors getting spooked by a big gilt sale that didn’t have much to do with any of the factors outlined above. 

We’re not expecting things to get as bad as they did back in 2022 when former Prime Minister Liz Truss’ mini-budget debacle resulted in a full-blown crisis of investor confidence in gilts and UK assets more generally. Nevertheless, the rout has wiped out a hefty chunk of the £9.9 billion so-called ‘fiscal headroom’ that the Budget was supposed to deliver. That leaves the government with painfully little wiggle room to spend without risking breaking its fiscal rules (in this case, to have national debt falling as a percentage of GDP within five years). 

A silver linings playbook?

Despite the bleak headlines, Higher bond yields can be positive for investors in several ways.

First, while they dent gilt prices, they also mean more coupons (income) relative to your initial investment. That means investors are being paid very attractive levels of income, regardless of whether there’s any change in gilt values from here. We think there’s a ceiling on how much further government bond yields will rise. Indeed, it seems pretty likely to us that gilt yields across short to very long maturities will dip below their current 4.5-5.5% level at some point. If that happens, decent capital gains could be on offer. (As a bit of an aside, one of the reasons why we think investor demand for gilts will hold up, and support gilt prices, is because low-coupon issues are a very tax-efficient option for higher-rate tax payers.)

Secondly, as gilt yields have risen, that’s driven down their duration (the measure of how sensitive a bond’s value is to changes in prevailing yields). The maths here is complicated, but the bottom line is that today’s higher-yielding gilts seem to offer a really attractive risk/reward trade-off.

And, finally, more generous gilt yields reinforce gilts’ ability to serve as a valuable counterweight to any volatility in the prices of stocks and other ‘risk assets’.

With investors now expecting shallower rate cuts and anticipating a lot of new gilt issuance, UK debt markets are likely to stay tense – and volatile. But there could be some silver linings lurking behind the storm clouds…