UK borrowing prices soar to 27-year excessive: What are gilts and the way do they work?

The cost of borrowing soared to its highest level for more than a quarter of a century this week as gilt yields continue to rise.

Just months after the Budget, the yield on 30-year gilts reached more than 5.25 per cent on Tuesday, for the first time since 1998 – and today have ticked over 5.34 per cent.

Meanwhile, the yield on a 10-year gilt is up to 4.8 per cent – the highest level since the financial crisis. 

The yield, which measures how much it costs the government to borrow, is now higher than after Liz Truss’ mini-Budget, sparking fears it could push up the cost of borrowing for households and businesses too.

So what are gilts, why are they rising and what does it mean for households and the economy?

What are gilts?

The Government generally spends more than it raises in tax which means that it needs to borrow money.

It can do this by issuing government bonds – known as gilts – which act as an IOU, but the Government has to pay interest on the loan.

They’re considered a relatively safe investment because like other bonds, the borrower promises to pay back the loan after a fixed period during which it will pay interest.

They’re also lower-risk compared to other bonds, like corporate bonds, because the issuer is the Government.

The three most important things to look at are the issuer (in this case, the Government), the coupon (the rate at which the issuer pays interest) and the maturity (the date the loan will be repaid).

There are different types of UK government gilts, spanning from short-term – between one and two years – all the way up to 30 years. 

The longer term the investment, the higher the yield, which is the annual return the investor receives if they hold it to maturity.

Why do the price of gilts change?

Gilts are traded like other investments so they can be bought and sold above or below the price they were issued at.

This price changes depending on whether investors think that the gilt can be repaid within the fixed period. 

It also depends on where interest rates have been set and when central banks change the base rate, gilt prices tend to change too.

Gilt prices and interest rates have an inverse relationship. If interest rates increase, gilt prices tend to fall. 

This is because investors are likely to find better returns elsewhere, including with new gilts issued with higher coupons.

On the other side, when interest rates are cut, newer gilt issuances pay less in interest, so existing gilts look more attractive.

Gilt prices and gilt yields also have an inverse relationship. Falling gilt prices mean higher gilt yields and when gilt prices rise their yields fall.

For example, if a bond is issued at £100 with a 3p coupon, it has a 3 per cent yield. But if the price rises to £200, the coupon is still 3p but the yield falls to 1.5 per cent.

Why are gilt yields rising now?

Generally the cost of borrowing around the world have been rising following the pandemic and Russia’s invasion of Ukraine, pushing inflation higher.

However, UK gilt yields have risen further as investors anticipate the Bank of England to cut interest rates by 0.5 percentage points, with inflation likely to stay above the 2 per cent target. 

There are questions as to whether the UK can increase growth and keep inflation at bay.

Others have suggested that the spike in UK yields are a reaction to the Government’s plans to increase borrowing. However, short-dated debt has been rising across the board.

Bond yields have risen 0.5 percentage points in the US and UK, by 0.45 percentage points in Germany and 0.40 percentage points in France.

This is largely in reaction to persistent inflation, which are a particular threat to longer dated bonds, and Donald Trump’s introduction of tariffs.

‘If you’re holding a one year bond, you might take the view that if inflation rears its head again, it won’t be until close to when you can get your money back in any case, and can reinvest it at potentially higher rates,’ says Laith Khalaf, AJ Bell’s head of investment analysis.

‘If you’re locked into a 30 year bond, it’s a long time until you can redeem your bond at its par value, so any inflationary threat could leave your investment in the red for an extended period of time.’

Short dated debt has also been rising in recent weeks, albeit not as quickly, mainly because ‘markets are fearful that Trump’s immigration and tariff policies might spark an inflationary surge which causes central banks to keep rates higher for longer,’ says Khalaf.

‘UK gilts across all maturities have followed a similar path in the last few months, though longer dated debt started from a higher base, hence why it is now cresting above the levels seen in the wake of the mini-Budget.

‘You would expect longer dated rates to be higher in normal circumstances because of the ‘term premium’ built into the yield curve. Investors locking their money away for longer naturally demand a higher return for doing so.’

Peel Hunt analysts predict that the risks facing the global economy, not just the UK, is ‘unusually large’ so ‘we may have further to run before bond markets settle’.

What do higher gilt yields mean for investors and the economy?

Higher borrowing costs will make it harder for the Chancellor to meet her borrowing target and could see her increase taxes in the Spring.

Jason Hollands of Evelyn Partners says: ‘This is undoubtedly a blow to Chancellor Rachel Reeves whose credibility with the markets and business leaders has been bruised by the Budget, as it is a sign of lack of confidence in the UK’s longer-term growth prospects and it also reflects the market adjusting for a significant amount of bond issuance over the coming year, given Labour’s borrowing plans.

‘The surge in long-term yields represents a real challenge for the Chancellor when it comes to sticking to her fiscal rules. 

‘Ultimately, it will pile pressure on either increased spending restraint, or the potential for further tax rises, neither of which are going to be palatable to the public.’

If inflation and fiscal challenges persist then the Bank of England could choose to move even slower to cut rates, which would lead to higher costs ofr mortgages and credit.

Richard Carter, head of fixed interest at Quilter Cheviot says: ‘The Bank of England remains cautious about slashing interest rates too aggressively, and the tepid demand from investors at the latest gilt sale underscores the uncertainty in the market. 

‘The short-term outlook is particularly unpredictable as we approach Trump’s inauguration, adding to the volatility.’

Despite the turbulence, experts say gilt yields remain an attractive opportunity7 for long-term investors because they remain above expected inflation levels.

‘For investors with a lower risk appetite, short-dated gilts still offer a promising avenue and are less sensitive to market fluctuations,’ says Carter.

Hollands adds: ‘Gilts look cheap compared to US Treasuries, albeit if Donald Trump’s agenda of tax cuts and deregulation overheat the US economy and provoke a return of inflation, then US Treasury yields may end up rising higher. 

‘However, as of now we think nominal gilts have the edge over Treasuries. 

‘One simple way to get exposure to the gilt market is via low-cost passive fund like the iShares Core UK Gilts UCITS ETF or the Vanguard UK Government Bond Index fund.’