Bond Watch: UK borrowing costs rise ahead of the Budget

Welcome to interactive investor’s ‘Bond Watch’ series, covering the latest market and economic news – as well as analysis – that is relevant to bond investors.        

Our goal is to make the notoriously complicated world of bond investing simpler, by analysing the week’s most important news and distilling it into a short, useful and accessible article for DIY investors.             

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Why gilt yields are rising 

Gilt yields have risen above levels not seen since the spring, as investors express concerns about government borrowing and economic stability ahead of the 30 October Budget.  

The 10-year gilt now pays 4.2%, up from 3.8% a month ago, while shorter-term bonds pay around 4%. When bond prices fall, this causes yields to rise, as investors are paying less for a fixed coupon, therefore increasing their returns.  

But not all gilts are affected equally. Most ii customers use gilts as a savings tool by holding short-term bonds to maturity, such as UNITED KINGDOM 0.25 31/01/2025 (LSE:TN25)and UNITED KINGDOM 0.125 30/01/2026 (LSE:T26), which mature in January 2025 and 2026. 

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These “ultra-short” bonds have a low “duration”, or sensitivity to interest rates, and generally do not experience big prices swings. Instead, prices gradually tick towards the £100 redemption value as the bonds near maturity. 

The same is not true of longer-dated bonds however, with the likes of UNITED KINGDOM 0.5 22/10/2061 (LSE:TG61), maturing in a little under 40 years, experiencing considerable volatility. TG61 dropped from £32 to £29.50 over the past month. 

Meanwhile, 4¼% Treasury Stock 2036 (LSE:T4Q), which matures in March 2036, saw its price fall from £103 to £99 over the past month.  

Rising yields are linked to worries that Chancellor Rachel Reeves may relax the UK’s fiscal rules, which limits government debt relative to gross domestic product (GDP), in order to not increase taxes as much as expected. 

A less fiscally responsible government can spook investors in UK government debt. By exiting the market and selling gilts, investors increase borrowing costs for the UK government. This puts pressure on the government to control its spending, or it risks paying more for borrowing.  

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This is what happened two years ago during the Liz Truss mini-budget, where a series of unfunded tax cuts were announced.  

While not at this point yet, it is a warning sign to the Labour government that debt markets will vote on how the government acts.  

The other worry for gilt investors is that inflation is not yet beaten. Higher inflation means the Bank of England has less scope to cut interest rates, which is one of the key things that leads to higher bond prices.  

Deutsche Bank thinks that UK CPI will drop to 1.8% in the 12 months to September, but will then begin increasing again as higher energy costs are passed on to consumers. It thinks that inflation will average 2.4% in 2024 and 2.5% next year.