A century-long favorite among global investors, UK government bonds, also known as gilts, are facing a severe test of their appeal as volatility has surged, at times even exceeding the wild swings seen in stock markets. Top asset management giants from Wall Street are warning that holding what was once one of the most popular bond trades of the past hundred years now requires nerves of steel. Once considered "cheap and safe," UK gilts have been transformed into high-volatility assets amidst Middle Eastern conflict, fiscal anxieties, and shifts in market structure.
During the latest round of Middle Eastern hostilities that began in late February, the UK gilt market has been more turbulent than its European and American counterparts. Even after a preliminary ceasefire agreement was reached this week, volatility has remained elevated. Since early March, the yield on the UK two-year gilt, which is particularly sensitive to geopolitical news, has moved by at least 10 basis points on 12 trading days, marking the most unstable period for gilt trading since the UK government's credibility crisis in 2022.
This intense volatility has prompted major Wall Street asset managers like Vanguard International and Royal London Asset Management to adopt a more cautious stance towards UK gilts. Other fund managers, including Insight Investment and M&G Investments, have also warned that volatility is likely to remain high for an extended period.
The UK gilt market, once a "crowded trade," is experiencing a major shake-up as it becomes highly unstable. "The UK has recently been the market most exposed to this type of geopolitically-driven, high-volatility, and exceptionally sharp price action," said Ales Koutny, Head of International Rates at Vanguard, who has unwound his aggressive bets on UK bonds outperforming continental European assets. "We still think UK assets look cheap, but now you need a stronger stomach to handle this volatility."
As illustrated in comparative charts, the volatility of UK gilt yields far exceeds that of similar markets. These sharp swings are making some investors wary of their exposure to UK government debt. Prior to the outbreak of conflict involving Iran, UK gilts had become one of the most crowded trades in fixed income. Investors had anticipated that the Bank of England would embark on a rate-cutting cycle due to a weakening labor market, which was expected to push UK yields significantly lower. The new geopolitical conflict in the Middle East and the resulting spike in energy prices have disrupted these optimistic expectations. Investors are now forced to contemplate the possibility of the Bank of England resuming interest rate hikes.
"UK gilt assets have looked exceptionally cheap for about the past year," said April LaRusse, Head of Investment Specialists at Insight Investment. "You're now in a situation where, suddenly, everything we were focusing on before is being seriously questioned." LaRusse pointed out that due to the UK's open economy, significant fiscal and trade deficits, and reliance on imported energy, it is more vulnerable to inflation and stagflation shocks compared to other developed nations.
As shown in charts, UK gilt yields are the highest among developed markets. The 30-year UK gilt yield has remained above 5% for over a year. UK gilts continued to fall on Friday, giving back some of the week's gains. Yields rose by approximately 4 basis points across the curve, with the 10-year yield trading just below 4.80%. At the peak of volatility in March, this yield touched a startling 5.12%.
"This has been the most loved government bond market over the last three to four months," said Craig Inches, Head of Rates and Cash at Royal London Asset Management. "Within our global bond funds, we have held UK exposure, but due to the volatility, we are now keeping that risk exposure at a relatively low level."
Beyond the immediate impact of war, which has altered the fundamental pricing outlook for bonds, concerns surrounding the UK's fiscal prospects are also making the gilt market inherently more prone to sharp swings. Deficit worries were a key driver during the 2022 gilt crash triggered by the tax-cutting and spending plans of the government led by Liz Truss.
A bond fund that delivered strong positive returns last month, even as global government bond markets faced record selloffs fueled by "stagflation" fears catalyzed by the Iran conflict, is betting that sovereign yield curves will steepen globally. The bet is that as governments implement expansive, populist-leaning fiscal policies to cushion the blow from energy shocks, bond markets will soon demand a higher price. Specifically, rising term premiums could push long-dated global bonds into a "steepening storm," triggering a sustained climb in yields for bonds with maturities of 10 years and longer.
Guillaume Rigeade, Co-Head of Fixed Income at French asset manager Carmignac, which manages the fund, recently stated in an interview that as economies digest the growth impact of these shocks, governments are likely to respond with more aggressive fiscal stimulus. This, he argued, would significantly elevate term premiums and consequently push up yields on long-dated bonds (10-year and beyond). The 10-year US Treasury yield, often called the "anchor for global asset pricing," if driven persistently higher by term premiums fueled by fiscal stimulus, could trigger a new wave of valuation compression for popular risk assets like high-yield corporate bonds, tech stocks, and cryptocurrencies.
According to comparative performance data compiled by institutions, the Carmignac fund achieved a return of 0.5% in March, while a global government bond index fell sharply by 3.4%. This performance placed it second among 282 bond strategy funds in the Morningstar Direct EUR Flexible Bond category.
Recently, the trading behavior of UK gilts has resembled that of Italian government bonds during the Eurozone debt crisis years ago. Investors typically view the latter as a much riskier bet than ultra-safe bonds like German Bunds. Data compiled by institutions shows that over the past month, UK and Italian government bond performances have been largely aligned, both down 0.2%, with UK gilts performing slightly weaker.
Beyond unsettling investors, persistently high volatility is having broader implications for the UK economy. As interest rate swap markets gyrated violently, lenders withdrew mortgage products, leading to a significant drop in UK housing purchase demand in March. This turbulence also complicates the UK government's fiscal planning and muddies corporate financing prospects, as companies may become reluctant to issue debt.
However, other factors are also at play behind this volatility. As a relatively small sovereign bond market, swings in the UK market can appear magnified compared to larger, more liquid bond markets. Simultaneously, changes in the demand structure have made gilts more susceptible to sentiment from relatively less stable investors, such as hedge funds that often use borrowed money to enhance returns. Demand from more stable buyers, including pension funds known for their long-term, steady, and cautious approach, has declined.
"The structure of our core government bond market has changed dramatically over the last five years or so," said Andrew Bailey, Governor of the Bank of England and Chair of the Financial Stability Board, on Thursday. "There is more leverage in the system, and pricing in the market does tend to move around more."
The next major test will come with local elections in May, which are shaping up to be a particularly tough examination for Prime Minister Keir Starmer's ruling party. Starmer faced calls to resign from within the Labour party last year, and the prospect of a potential leadership contest looms large in the minds of global gilt investors, who remain haunted by the 2022 crisis that led to the downfall of former Prime Minister Liz Truss.
Collectively, these risks suggest that global "fast money" strategists, such as those at leveraged hedge funds, may adopt an even more cautious approach to the UK bond market. "There is a sort of semi-permanent risk premium here," said Andrew Chorlton, Chief Investment Officer of Fixed Income at M&G. "It's still paying the price for things that happened under a completely different government, a completely different set of policies."