UK government borrowing pressures intensified at the start of September, with 10-year gilt yields topping 5.2% – the highest level since the global financial crisis. 30-year yields hit highs not seen since the late 1990s. This has been a trend building all year, since the outbreak of conflict in the Middle East.
The rise is largely down to higher inflation expectations, triggered initially by the conflict with Iran from the end of February and the resulting rise in oil prices. With tensions flaring again more recently, oil prices have climbed once more. Higher inflation means investors demand a greater return for holding fixed income.
What’s driving higher gilt yields
The geopolitical backdrop has consequences well beyond energy prices.
The nature of conflict itself is changing, and asymmetric warfare has become more prominent, prompting long-standing alliances to be questioned in ways few would have predicted a few years ago. As geopolitical risk rises, so does pressure on governments to increase defence spending – and that costs money.
Inflation compounds the problem – everything costs more, including the provision of public services. Investors, seeing that governments are already heavily indebted and likely to become more so, demand higher returns to compensate.
This is a headache for both Prime Minister Andy Burnham and Chancellor John Healey. Higher borrowing costs mean a bigger interest bill, which squeezes the money available for everything else. Cutting spending elsewhere is politically difficult.
It's something of a vicious cycle. As interest costs rise, pressure builds on government finances, which unsettles investors further and can push borrowing costs even higher.
A global story, not just a UK one
This isn't only about inflation expectations. There's also a wave of new bond supply hitting the market globally, including large issuance from the big artificial intelligence (AI) hyperscalers financing the enormous capital spending required for AI development. What's happening in the US matters a great deal here. US Treasury yields act as the benchmark rate against which most other investments are priced. As the saying goes, when America sneezes, the rest of the world catches a cold. With US midterm elections approaching in November, Republicans are acutely aware of the affordability issue, having lost ground to Democrats in local, gubernatorial and mayoral elections.
Treasury Secretary Scott Bessent has responded with an unusual intervention in the longer-dated bond market, announcing a programme to buy double the usual amount of long-term government debt, funded by increased borrowing at the shorter end. Meanwhile, the Federal Reserve has a new chair, Kevin Warsh, whose early statements to the market were, for many, difficult to read. What does seem clear is that he's alert to inflation risk – so the rate cuts President Trump had been hoping for may not materialise as quickly as some expected.
What this means for investors
For UK investors who buy gilts directly and hold them to maturity, the higher yields on offer can now be locked in. This can be particularly attractive because gains on gilts held directly are exempt from capital gains tax. Yields are variable though, and past performance isn’t a guide to the future.
Some investors may prefer low-coupon gilts, where more of the return comes in the form of capital gain to make the most of that exemption. Remember though, these do tend to be what investors call ‘higher duration’, which means ‘higher risk’. This means that if you did need to sell before the maturity of the bond, you would be vulnerable to bond price moves.
Thinking about your personal situation is important.
Investors who choose not to hold to maturity should be aware that trading every headline is difficult, whether that's political speculation here or shifting rate expectations in the US. Investors should be wary of making long-term decisions on the back of a single speech or news story. What ultimately happens to inflation, growth and rates matters far more than any one day's headlines.
If you hold gilts within a Stocks and Shares ISA, they're already free of tax on both income and gains. The same applies to gains within a Self-invested Personal Pension (SIPP), though remember that income drawn from a pension is taxed at your marginal rate. But remember, tax rules can change and benefits depend on individual circumstances.
Whether you're talking about shares or bonds, the same principle applies: diversification matters. Investors should stay focused on the long term, understand the risks they're taking, and think about how each individual investment fits into a broader portfolio.
This article is for information only and not personal financial advice. Investing can help your money grow, but the value of investments can rise and fall, so you could get back less than you put in. Investing is for the long term, typically 5 years or more.
If you’re not sure whether investing is right for you, a financial adviser can help.