The interest rate on UK 30-year gilts has reached 5.37% for the first time since 1998. Meanwhile, 10-year gilt yields have also experienced a sharp rise to 4.79%; the highest level since the financial crisis.
The surging levels are shadowing a rise in US bond yields, driven by signs of a still strong US economy, as well as persistent inflation.
Laith Khalaf, head of investment analysis at AJ Bell, said: “The bond market has taken fright from the growing sense of inflationary pressures in the air. There are no easy answers of why markets move, especially over a short time frame and sometimes it’s simply a matter of momentum.
“However, the fact yields are rising on both sides of the Atlantic does suggest the new year has brought with it a focus on the incoming US president and the potential for his trade and immigration policies to be inflationary, which has implications for both economies. Bond investors might also be looking at the giant stacks of government debt already on the books on both sides of the pond and saying thanks but no thanks.”
Lindsay James, investment strategist at Quilter Investors, said: “Term premium, the additional yield investors demand for lending long-term money, has been on the rise, with one factor being the pure level of uncertainty around the future path of inflation and the productive potential of the economy. However, a key factor remains the sheer size of the bond sales by both the UK government and the Bank of England that foreign investors typically mop up.
“With the Bank of England reducing its Asset Purchase Facility to the tune of £100bn a year as part of its reversal of quantitative easing, alongside the government’s hefty bond issuance that will push towards £300 billion this fiscal year, the abundant supply of bonds also appears to be driving up yields at a time when the economy is showing cracks.”
The sharp spike has led to growing concern that the government will find it harder to meet its borrowing targets, prompting further tax increases.
However, James said it was unlikely that the Chancellor would announce further tax rises, with indications that corporates are already responding to the decision to raise National Insurance on employers by raising prices and cutting headcount, pushing the UK further towards stagflation. James said spending cuts is a more likely outcome.
“With public services already struggling and the investment budget seen as the source of future growth, the decision of where cuts could fall will be crucial. However, wherever the cuts may fall, her goal of raising economic growth has just become that bit harder,” James added.
Khalaf said investors should not underestimate the potential for rising bond yields to spark a stock market correction if they remain elevated, especially against a backdrop of lofty US equity valuations; high levels of concentration in a few mega-cap stocks and the emergence of a step-change in technology which has the potential to both enhance and disrupt corporate profitability.
Khalaf said: “Existing bond investors will be nursing some modest losses as a result of the latest sell-off. The typical gilt fund is down 2.5% in the last three months, while the typical pension lifestyling fund is down 4.4%, as these invest in longer dated bonds. To put this in some context, in 2022 these funds fell by 24% and 36% respectively. We’re very, very unlikely to see such deeply negative returns given yields are starting from a much higher level, and bonds are also now paying some income, which can offset capital losses.
“Fresh bond investors might be licking their lips as yields rise and they are able to lock into higher rates. This is particularly the case for the band of short-dated low coupon bond investors, who have been using these bonds as a cash proxy to reduce their tax liabilities. If gilt prices continue to drop, an investment might fall into the red, but investors can still wait for maturity to simply collect the face value of the bond.”
Rising gilt yields may also lead to firmer pricing in the mortgage market, which will impact those looking to remortgage or buying their first property.
Impact on pensions
David Brooks, head of policy at Broadstone, said LDI funds have been actively managing their cash positions in response to shifting investor sentiment and market volatility and the impact of rising gilt yields on pension schemes is likely to be contained.
He explained: “Improvements to collateral management and waterfall structures since the 2022 yield crisis have significantly strengthened market resilience and ensured schemes are better prepared to handle fluctuations.”
Brooks said trustees and sponsors should continue to focus on monitoring hedging levels, maintaining adequate collateral buffers and rebalancing portfolios where appropriate.
“The higher-yield environment also creates opportunities to review de-risking strategies, particularly for schemes that have benefitted from improved funding positions. In addition, trustees may need to review commutation factors to ensure fair value and potentially review covenant positions where sponsor’s borrowing costs have risen,” he added.
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