Bond Watch: what ‘vulnerable’ UK finances mean for gilts

When an investor owns gilts, they are lending money to the UK government. Like any loan, you want to make sure that you will get your money back alongside the promised interest payments, and this is determined by the financial position of the borrower.

However, because gilts are traded throughout the life of the loan, it is also a bonus if your gilts rise in value when you hold them, as you have the opportunity to sell them at a profit and lock in a tax-free capital gain.

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While it’s extremely unlikely that the UK government will ever default, the financial health of the UK is still a very important factor when you decide to invest in its debt. This is because rising inflation could eat into returns, and also because you could be sitting on a “paper loss” if gilt prices fall.

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So, gilt investors should pay attention to the Office for Budget Responsibility’s (OBR) report this week that concluded that the “UK’s public finances have emerged from a series of major global economic shocks in a relatively vulnerable position.”

This statement sparked a gilt market sell-off, sending yields on the 10-year gilt to 4.65% (from around 4.5%), and the 30-year to nearly 5.5% (from 5.3%). Gilt yields rise when investors sell UK government bonds – this is generally linked to higher inflation expectations (which may cause the Bank of England to raise interest rates) or due to worries about public finances.

Higher gilt yields raise the cost of new borrowing, which in turn makes it more difficult to fund budget deficits.

Here are three key takeaways from the OBR report.

The UK is really indebted

The OBR found that, as of the end of 2024, the UK government deficit stood at 5.7% of GDP, making it the third-highest among 28 advanced European economies, and the fifth-highest among 36 advanced economies (after France, Slovakia, the US, and Israel).

On top of this, with UK 10-year gilts at 4.5% as of the end of June (yields are now higher), the OBR finds that the UK has the third-highest borrowing costs of any advanced economy (after New Zealand and Iceland.)

It is struggling to control is debt addiction

Having a large debt-to-GDP ratio is one thing, but the direction of the funding deficit is another important factor.

Unfortunately for bond holders, the OBR finds that while reducing public debt as a share of GDP has featured in eight out of nine UK fiscal frameworks since 2010, underlying debt has risen by 24% of GDP over the past 15 years and by 60% of GDP over the past 20 years.

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The OBR report says the rise in debt since 2010 is partly due to the scale of the two major shocks that the global economy has experienced over this period: the Covid pandemic and the energy crisis.

It adds: “But in the aftermath of the shocks, debt has also continued to rise and borrowing remained elevated because governments have reversed plans to consolidate the public finances.

“Planned tax rises have been reversed, and, more significantly, planned spending reductions have been abandoned. The more persistent fiscal deficits and ratcheting up of debt that resulted have been accommodated by successive loosening of the fiscal rules.”

This will have an impact on government debt markets

The UK is not alone when it comes to worsening fiscal outlooks, and a rise in advanced economy government borrowing around the world fuels higher borrowing costs for everyone. For example, if US government bond yields rise, this generally causes other government bond yields to rise around the world.

All this could be bad news for government bond holders, particularly longer-dated bonds, which are more sensitive to the longer-term fiscal outlook. Shorter-dated bond yields are more closely tied to changes in central bank interest rates.

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The OBR says: “Government borrowing costs have risen across the world and long-term gilt yields are now higher in the UK than at any point since the start of the century. Uncertainty about the future path of inflation and fiscal policy in the US, Europe, and Japan has fuelled persistent volatility in sovereign bond yields since the start of the year.

“And governments in the UK and across advanced economies have shortened the maturity of their new borrowing and are increasingly looking abroad for investors as domestic appetite for their longer-dated debts wanes.”