This is why no one should be bored by UK bond prices

This time has been different. UK government bond – also known as gilt – yields have risen even as the economic outlook has become more uncertain.

That matters not only for professional investors, but also for anyone with money in a pension, stocks and shares ISAs, bond funds or a multi-asset portfolio. Understanding what’s driving gilt yields can help investors make better decisions about where to put their money.

A different macro backdrop

At a high level, gilt yields reflect three core drivers: expectations for future interest rates, the path of inflation and the additional return investors demand for holding longer-term bonds (the “term premium”).

In the current environment, all three have moved higher.

The key catalyst has been a renewed rise in energy prices, which has pushed up inflation expectations. At the start of the year, markets expected UK inflation to fall back below the Bank of England’s 2% target — set by the government — paving the way for rate cuts. Instead, higher oil and gas prices have complicated that outlook.

This leaves policymakers in a difficult position. Inflation risks remain, yet growth is weakening. Markets have responded by pricing in a more cautious path for interest rates. That repricing has pushed gilt yields higher.

Why has the UK been hit harder?

Although bond markets around the world have faced similar pressures, the UK has been particularly sensitive. There are two main reasons.

First, inflation remains a concern. Many investors still remember the sharp rise in UK inflation in 2022 and 2023. Because inflation stayed higher for longer than many expected, markets now react more quickly whenever there is a risk that inflation could rise again.

Second, investors are paying close attention to government finances. The UK needs to borrow significant amounts to fund public spending, and markets want reassurance that borrowing remains sustainable.

As a result, political events, Budgets and fiscal announcements can have a greater impact on gilt yields than in some other countries.

Are gilts still a safe haven?

Gilts have traditionally been seen as one of the safer parts of an investment portfolio. However, recent years have challenged that assumption.

Bond prices have been more volatile than many investors are used to, and gilts have not always provided the protection against stock-market falls that investors expect. At times, both shares and bonds have fallen together.

That doesn’t mean gilts have lost their value. Government bonds still play an important role in many portfolios, particularly for investors seeking income or looking to reduce overall investment risk.

But it does mean investors may need to look more carefully at the type of bond exposure they own and how it fits with their financial goals.

How do higher gilt yields affect investors?

One benefit of higher gilt yields is that bonds now offer a much more attractive level of income than they did for most of the past decade.

Bond returns come mainly from two sources: income from regular coupon payments and changes in the bond’s price.

Today, the income component is becoming increasingly important. Investors can earn a higher starting yield without having to rely as heavily on bond prices rising.

This is particularly relevant for retirees and income-focused investors who may have struggled to generate income from lower-yielding bonds in previous years.

However, investors should remember that bond prices can still move up and down, especially for longer-dated gilts, which tend to be more sensitive to changes in interest rate expectations.

What should investors consider?

The current environment presents both risks and opportunities. Higher yields mean bonds can once again provide a meaningful level of income and potentially improve long-term returns.

At the same time, investors should not assume that government bonds will always behave as they have in the past. Inflation, interest rates and politics are all likely to remain important drivers of market performance.

For some investors, shorter-dated bonds may offer a useful middle ground, providing attractive yields while reducing exposure to large swings in bond prices. As always, investors should make sure their portfolio reflects their own objectives, time horizon and tolerance for risk.

The bottom line

The gilt market is adjusting to a world of higher inflation uncertainty, shifting interest-rate expectations and greater scrutiny of government finances. While this has created volatility, it has also pushed yields to levels that many investors have not seen for years.

For savers, pension holders and investors, that creates opportunities as well as challenges. Bonds may not offer the same level of stability they once did, but higher yields mean they can once again play an important role in generating income and supporting portfolio diversification.

As always, understanding the risks and rewards is key to making the most of the opportunities available.

Matthew Amis is investment director at Aberdeen Group.