The first quarter of the year saw heightened volatility in UK government bonds, a usually uneventful corner of UK capital markets. Still, the drama was focused on the start of the year, with January seeing a spike in yields. At the time, veteran US investor Ray Dalio even warned the UK government was in a “death spiral” over debt.
Since then market anxiety has faded, especially as the chancellor, Rachel Reeves, delivered a Spring Statement at the end of March that appeased investors in UK government debt about spending and taxation plans.
UK Bonds Make a Volatile Start to 2025
Just two weeks into 2025, investors started selling UK government debt or gilts, especially long-term bonds, such as those with a 30-year maturity.
January’s selloff, as well as the price recovery that followed, are visible in the Morningstar UK Gilt Index.
As prices move in the opposite direction to yields, the yield on the 30-year gilt hit levels last seen in the late 1990s and the 10-year gilt spiked to levels seen in 2008, the year the financial crisis hit home.
On one level, the bond markets were flagging concerns about the long-term viability of the UK government’s fiscal position, as well as nagging worries about short-term issues raised in the Autumn Budget of October 2024. It was also part of a global revaluation of sovereign government debt related to the start of a new Trump administration.
Whether a global trend or not, this was Labour’s problem right now, because higher yields mean governments have to pay investors more to compensate for the risk of holding the bonds; it was also a problem for a future government decades from now because they would still have to pay these 5%+ coupons into the 2050s.
At the time analysts at Morningstar Investment Management told clients not to panic, especially with the market chaos of late 2022, when yields spiked and the pound slumped after the Liz Truss Mini-Budget, still fresh in investors’ minds.
“Market moves in the past few sessions have not caused anywhere near the same level of concern in markets and we do not believe there’s any reason for alarm,” the analysts said in January.
Morningstar fixed-income analyst Evangelia Gkeka explained the dynamics of the market moves in a video.
UK Chancellor Calms Bond Markets
Two months later, March’s Spring Statement saw the chancellor under pressure to justify the spending plans of a government only in power since July 2024. Anxiety over the size of the “fiscal headroom,” the buffer a government builds between spending needs and money brought in, was allayed. Government budgets would balance by 2029-2030 to the tune of nearly £10 billion; the next general election needs to be held by August, 15, 2029, so the timing is perhaps not a coincidence.
While that £10 billion buffer was reassuring to markets, some fund managers said that this could have been higher.
“£10bn headroom is arguably not enough headroom compared to a planned £1.5 trillion of spending and uncertainties ahead. The historical average has been closer to £30bn but recent governments have run it tighter. A £20bn number would have been more constructive for gilts,” said Shamil Gohil, fixed income portfolio manager at Fidelity International.
By constructive, this manager means that bond prices would rise, and yields would fall.
Gohil also said that UK bond investors could be in limbo until the next “fiscal event” in the autumn, the 2025 budget announcement.
“Gilts probably remain in no man’s land until the Autumn Budget as we will likely see some fiscal slippage and buffer erosion from now until then,” Fidelity’s Gohil added.
In the meantime, the chancellor needs better growth figures, which would lead to higher tax receipts and create a missing “feelgood factor” that encourages overseas investors to buy into UK debt. However, the Office for Budget Responsibility just cut its 2025 growth forecast from 2% to 1.
Longer-Term Yields Have Jumped
As the second quarter starts, the 2-year gilt is only one basis point higher than in April 2024, whereas the 5-year gilt is 43 basis points higher. Further along the yield curve, the 10-year gilt yields 71 basis points more than the same point last year, while the 30-year yields 83 basis points more.
These are substantial moves in the bond market. After all, bonds are traditionally added to portfolios to reduce equity market volatility.
An investor willing to lend the UK government money for 30 years, and hold the bond to maturity, will get paid 5.25% for doing so for three decades. This is at a time when inflation is below 3% and the Bank rate is 4.50% and likely to be cut again in May. August is also a potential month for a cut, which would take rates down to 4% by the end of the year.
The Bank of England’s cautious approach to this rate-cutting cycle is one factor in bond yields, with “higher for longer” rates now seen as a reality by mortgage borrowers and cash savers alike. Where the “terminal rate,” or final BOE rate, will be at the end of the cycle is less clear. It will most likely be higher than in the era of low interest rates, whose nadir was the post-pandemic level of 0.10%.
Governments Are on a Debt Binge
Across Europe, there’s a new recognition that governments will need to spend more to fund defense costs, an ageing population and to confront protectionist policies of the US government. This has pushed up previously muted yields on eurozone government debt, closing the gap or “spread” with the UK.
One way sovereign governments do this is by issuing debt, a politically more astute way of raising money than hiking direct taxation. But markets react badly to too much of this activity – issuing too much debt can “flood” the market with unwanted securities, reducing their appeal and their prices. Bond investors register their disapproval for government fiscal plans by selling debt, which pushes up yields.
Current bond yields are appealing to investors, but in the past the UK government has failed to “fill” or sell the required amount of bonds in auctions of new gilts.
To this end, the Spring Statement brought some relief for debt investors as issuance will be curbed at a time when the Bank of England is increasing supply by selling UK debt into the market.
“The market welcomed the Debt Management Office (DMO)’s bond sale forecast with open arms, with overall issuance likely lower than expected,” Michael Sheehan, fixed income fund manager at EdenTree Investment Management, said.
How Currency Moves Affect Bond Returns
More factors than demand for debt are at work here. The US dollar has fallen against the pound and euro. At the start of the year, one pound would buy $1.26, now that’s $1.29. Recall that in the 2022 Mini-Budget fiasco, the pound nearly hit parity against the dollar before recovering.
There’s a feedback loop that operates between currencies, interest rates, inflation and bond yields.
Stronger currencies can reduce equity investment returns for domestic investors but increase the appeal of the country’s assets, such as bonds. Currency strength reflects actual and expected interest rates, and the UK’s are higher than in the eurozone and similar to those in the US. So sterling-denominated assets currently offer a greater yield than those in Europe, for example. This, in turn, increases demand for sterling as a currency.
Are UK Government Bonds a Buy for Yield?
One aspect of the current higher bond yield environment, with 10-year yields around 4.60%, is that gilts are more appealing for those chasing high returns. These yields are higher than what investors can achieve holding cash or FTSE 100 stocks. While cash is a risk-free asset, UK government debt is considered low risk because the UK is very unlikely to default on its obligations. UK credit ratings, a key factor in determining the riskiness of sovereign debt, are one rung below the highest “AAA” rating; Morningstar DBRS rates the UK as AA with a stable outlook.
Morningstar portfolio manager Nicolo Bragazza said: “If we look at yields on an absolute basis, it’s clear UK yields are now quite attractive on a historical basis. Given the limited fiscal headroom the government has to borrow more money – and the higher bank rate compared to other developed markets – there is a good chance that downside is larger than the upside for UK yields.
“This could make UK bonds quite a compelling opportunity for investors willing to hold them through the volatility.”
UK Government Bond Outlook for Q2
While the first quarter’s heightened volatility has receded, investors in UK debt cannot be complacent in the second quarter.
Inflation is lower than in 2022 but it’s still above target and is forecast by the Bank of England to rise again. “The UK may need to get accustomed to higher inflation and higher rates for the foreseeable future,” Fidelity’s Gohil said. This would make the case for holding interest rates, which is likely to support short-term yields.
One clear way the UK government’s buffer could shrink is through the imposition of tariffs on the UK by the US. Another is that UK economic growth falls short of the Spring Statement’s forecasts. The UK economy shrank in January from December, for example.
This would mean the government will need to revisit previous spending, taxation and borrowing plans, especially as it has already pledged not to raise VAT, income tax or employee national insurance before the next election. This will likely reduce the fiscal buffer, forcing the state to either cut spending further or borrow more money.
Mark Dowding, chief investment officer at RBC BlueBay Asset Management, said the government will be put in a tight spot by bond markets.
“It is hard not to think that OBR estimates on growth and interest borrowing costs are too optimistic and it seems that the gilt market is already wanting to push for a commitment for higher taxes or additional spending cuts at the Autumn Budget.”
He said that one potential solution for the government is for the Bank of England to pause its program of quantitative tightening or QT, where it sells government bonds into the market. This is a reversal of the period of quantitative easing when the Bank of England bought UK government debt to increase the supply of money in the economy.
QT is costing the Treasury money at a time when borrowing costs have risen and public finances are tight, RBC’s Dowding said. It’s also increasing the supply of government debt in the market.
“Since the losses the Bank of England is making on gilt sales go straight into the Budget, this is hurting the government badly. There seems no need for QT at this point and ending this harmful policy would help the supply/demand picture in the gilt market as well as benefiting government finances.”
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
