Gilt Yields Reach Multi-Decade Highs
Global forces are driving bond yields higher, but UK fiscal concerns are adding further pressure
UK gilt yields have risen sharply in recent weeks, with 30-year yields reaching levels not seen since the late 1990s and 10-year yields climbing to their highest levels since before the Global Financial Crisis. While the move has attracted significant attention domestically, it would be a mistake to view it as purely a UK phenomenon.
Government bond markets across the developed world have come under pressure as investors reassess inflation risks, public debt levels and the long-term outlook for economic policy.
A Global Repricing of Risk
The recent rise in gilt yields is part of a broader sell-off that has affected government bond markets worldwide. Yields have also moved higher in the United States, Europe and Japan as investors demand greater compensation for lending money over long periods.
One reason is the growing belief that inflation risks have not disappeared. While inflation has fallen significantly from the levels seen in 2022 and 2023, geopolitical tensions, rising energy prices and ongoing supply-side uncertainties have raised questions about whether inflation will settle comfortably at central bank targets. For long-term investors, even a small increase in inflation uncertainty can justify a higher required return.
Markets have also become increasingly convinced that interest rates are likely to remain higher for longer. Economic growth has generally remained more resilient than expected and investors are increasingly pricing a world in which policy rates remain elevated for longer. That adjustment has naturally fed through into government bond yields.
Beyond inflation and interest rates, investors are also becoming more focused on government balance sheets. Across developed economies, debt levels remain high following years of fiscal support, while ageing populations, infrastructure investment requirements and increased defence spending continue to place pressure on public finances. Governments are expected to issue substantial volumes of new debt over coming years and investors are demanding a higher return to absorb that supply.
Collectively, these factors have contributed to a rise in the term premium, the additional compensation investors require for holding long-dated government bonds. During the era of quantitative easing, central bank bond purchases helped suppress this risk premium. Today, investors appear to be reassessing the risks associated with long-term government lending and demanding greater compensation in return.
Why the UK Is Under Greater Pressure
While the global backdrop explains much of the move in yields, the UK faces a number of challenges that may be exacerbating the rise in gilt yields. The UK currently has the highest government bond yields in the G7, with 10 year yields around 0.4% higher than the US and 1.8% higher than Germany.
The first is the state of the public finances. Public debt remains close to historic highs as a proportion of GDP, while debt-servicing costs have increased materially following the rise in interest rates over recent years. This leaves relatively little room for policy missteps and increases the market's sensitivity to any indication that borrowing may rise further.
Investors also continue to place significant emphasis on fiscal credibility. The events of 2022 demonstrated how quickly confidence can deteriorate when markets become concerned about the sustainability of government borrowing plans. Research suggests that UK gilt yields have become increasingly influenced by domestic risk factors since that period, particularly at longer maturities.
Political developments have therefore become an important consideration for markets. Investors are closely monitoring future government spending plans and assessing whether growth ambitions can be delivered without undermining fiscal discipline. Investors may be more willing to absorb additional borrowing where there is confidence that spending will support long-term economic growth. As borrowing costs rise, maintaining investor confidence becomes increasingly important. The upcoming Autumn Budget will be an opportunity for the government to demonstrate credibility to bond markets.
There are also structural factors at play. The movement to quantitative tightening and shifts in investor behaviour have altered the balance between supply and demand in the gilt market. Domestic pension schemes are buying fewer gilts in recent years, so the government is more reliant on international investors, many of which will be investing in gilts for tactical reasons making them more likely to offload allocations when the time is right.
Good News for DB Pension Schemes
Although rising yields present challenges for governments, the implications for many UK defined benefit pension schemes are more positive. Higher yields reduce the present value of future pension liabilities, helping to improve funding levels. This has been a significant driver of the improvement in scheme funding positions seen since 2022.
The extent to which schemes benefit depends on their liability hedging arrangements. Schemes with high hedge ratios will have seen much of the reduction in liabilities offset by losses on their hedging assets, helping to stabilise funding levels. In contrast, schemes with lower levels of hedging are likely to have experienced a more direct improvement in funding positions as liabilities have fallen faster than assets.
Importantly, the current environment may also present an opportunity. Long-dated gilts now offer yields that would have seemed unlikely only a few years ago, providing schemes with a more attractive entry point for liability hedging and de-risking strategies. Trustees of schemes that remain under-hedged may therefore wish to revisit their hedge ratios and consider whether current market conditions provide an opportunity to lock in recent funding gains and reduce exposure to future interest rate and inflation volatility.
While higher yields signal challenges for public finances, they continue to support funding levels across much of the defined benefit universe. For schemes progressing towards low dependency or buy-out, the current environment may offer an attractive opportunity to strengthen liability protection and secure progress made in recent years.
John Plenderleith
Investment Consultant
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