Assessing risks in the U.K.’s risk-free rate

Government bond yields are based on a complex interplay between economic conditions, financial market dynamics and global factors. The credit quality of a country, interest rates, growth prospects, demographics and inflation expectations are some of the factors that drive the movement in government bond yields.

Global government bond yields have risen sharply over the past few years due to a number of factors: the end of quantitative easing (QE), inflation, rising interest rates, slowing growth and unsustainable debt levels. The bond market is taking an increasingly dim view of countries where unsustainanble budget deficits are feeding into ever-rising debt levels. Volatility has also increased dramatically since Q4 2024 with rising geopolitical risk.

Since 2022, yields on U.K. Gilts rose more than yields on bonds from other major economies. The U.K.’s borrowing costs are higher than both Italy’s and Greece’s, and the spread over German Bunds is at a multi-decade high (Figure 1).

Figure 1: Change in 10-year government bond yields

Many of the challenges facing the U.K., such as low growth, persistent inflation and high government debt, are present to varying degrees in other European nations. The level of U.K. gross government debt is in line with other major economics (excluding Germany), approaching 100% of GDP. France’s and Italy’s debt levels far exceed the U.K.’s.

So why are bond markets pricing U.K. debt at higher yields? The current differential in central bank interest rates between the U.K. and eurozone explains part, but not all, of the price differential. Contagion from the rise in U.S. Treasury yields may be a contributing factor, although observable economic factors do not explain why U.K. yields have broadly tracked U.S. yields since the U.S. election in November 2024. Comparisons to the chaotic spike in yields of Gilts in September 2022 are misplaced since the recent rise has been orderly and in parallel with higher U.S. Treasury yields.

Looking more closely, we see several key issues that could keep Gilt yields higher for longer. Some concerns are around the U.K. economy and budget, including the increase in debt and the deficit. Other issues are related to supply and demand dynamics in the Gilts market. We explore how each of these factors makes the Gilt market vulnerable to adverse shocks that are being priced into Gilt yields.

The U.K. has taken on more debt than any G7 country except Japan

Looking over the past two decades, the U.K. has added more to its debt pile, in terms of percentage of GDP, than any other G7 country, except Japan (Figure 2). The largest chunks of debt over that time period were accrued during the GFC and the COVID pandemic, similar to other G7 countries. Rising global bond yields reflect investor concerns about fiscal sustainability in a number of countries.

The U.K.’s track record is not particularly reassuring to bond markets looking for evidence that a government can reduce its debt to GDP ratio. The government has consistently run a budget deficit, even during the decade of austerity from 2011-2019, when government spending was reined in. A longer-term historical perspective, in the 50 years through 2023, shows that the U.K. government has only managed an annual budget surplus four times.

The impact of country-specific issues on bond yields is clear in Japan—but with a different outcome. Japan actually has one of the highest levels of government debt, but long-term yields have remained low because demand for Japanese bonds is strong because of the home bias in asset portfolios. Interest rates have been close to zero since 2001 in Japan and the domestic savings rate is high. Later in this article, we discuss how changing demand for U.K. debt might impact pricing in the future.

Figure 2: Change in government debt as a % of GDP, 2000-2022

Linkers are costing the government more money

The U.K. was one of the first developed economies to issue inflation-indexed bonds for institutional investors, with the first index-linked Gilt issued in 1981. The U.K.’s current stock of index-linked bonds (known as linkers) now accounts for a quarter of all government debt (Figure 3)—by far the highest out of all G7 countries. When inflation was low and stable, linkers had little impact on government finances. However, with inflation higher over the past three years, U.K. government interest payments rose. An increase of 2.2% of GDP in annual payments equated to approximately GBP 50 billion in extra interest payments, further constraining an already tight government budget.

Figure 3: Index-linked bonds across the G7 in 2023, % of total stock (LHS) vs. changes in net interest payments from 2019-2022, % of GDP (RHS)

Increasing supply faces declining domestic demand

Demand and supply dynamics are key considerations when assessing risks around the cost of government debt. The U.K. government issued GBP 241 billion worth of debt in financial year 2023-2024, and the figure is expected to rise to GBP 300 billion in 2024-2025. Concurrently, the Bank of England (BoE) has begun unwinding its holdings of long-dated securities, primarliy U.K. Gilts, that it accumalted through its QE program. At the peak in 2020, the BoE held GBP 895 billion in long-dated securities. BoE currently holds just under a third of all U.K. Gilts and will reduce its holdings by approximately GBP 100 billion per year.

Historically, defined benefit (DB) pension schemes were the largest holders of U.K. Gilts, as regulations allowed them to match the income stream from Gilts to their future liabilities. Many of these DB schemes are now fully funded and being sold to insurance companies, at a rate of about GBP 80 billion a year. Insurance companies do not have the same regulatory advantages for holding Gilts and prefer higher-yielding assets. As a result, the demand from pension funds and insurance companies has decreased significantly, from on average purchasing 65% of all Gilts in the 20 years through 2008 to 22% today (Figure 4).

With two of the the largest holders of U.K. Gilts reducing exposure to U.K. debt, concerns about the market’s ability to absorb future Gilt issuance may already be impacting pricing.

Figure 4: Holders of U.K. Gilts, by type, % of total

High level of foreign ownership is a risk

About a third of U.K. government debt is held by foreign investors, which is higher than other G7 countries (Figure 5). This figure does not include government debt owned by other governments. For example, the U.S. number would be higher as other governments such as Japan and China hold 14% and 10% respectively of all U.S. Treasuries.

Taking the BoE’s stock of Gilts purchased through QE out of the equation, the overseas ownership number rises closer to 40%. Compared to U.K. institutions and banks, foreign buyers are less likely to be stable holders of U.K. debt, especially during times of distress. For diversified global portfolios, owning sterling assets and having a sterling-denominated income stream is likely to be less in demand than euro-denominated assets, such as French government bonds. Current global central bank holdings highlight the general difference in demand: sterling-denominated debt accounts for around 5% vs. 22% for euro-denominated debt. The high level of foreign ownership and risk of capital flight could feed into increased volatility for Gilt yields.

Figure 5: Foreign holdings of sovereign debt (excluding official sector), % of total

Despite the circumstances that have been impacting Gilt prices, our base case remains that economic growth in the U.K. will gain momentum through 2025 and 2026, with interest rates simultaneously decreasing. In this scenario, receipts will rise—if fiscal discipline is maintained—and will reduce the government deficit.

The budget deficit is not the only impact on the debt-to-GDP ratio. The growth corrected interest rate—the difference between the interest rate paid on government debt (which raises the debt to GDP ratio) and the growth rate of economic output (which reduces it) plays an important part. If growth exceeds the interest rate by an amount larger than the budget deficit, the debt-to-GDP ratio will start to come down.

This level of growth should dampen fiscal sustainability concerns and, in turn, feed into lower bond yields. A 100-basis-point (bps) reduction in Gilt yields leads to a cumulative savings of GBP 21 billion over a five-year period, potentially giving the government more fiscal head room.

Less scope for property yields to compress

Property yields are comprised of the risk-free rate and a real estate risk premium. The pass through between Gilt yields and property yields is not 100%—rather, studies show it’s closer to 20%. The higher-for-longer bond yield environment means less scope for property yield compression in this cycle.

Looking at the historical spread between the risk-free rate and the All Property yield, the average spread was just under 150 bps in the decade before the GFC, rising to 360 bps in the decade after, due to the impact of QE on Gilt yields. Currently, despite the repricing in the U.K. real estate market (since the peak in June 2022), the spike in U.K. Gilts has pushed the current spread down to 70 bps.

Using our base case that long-term U.K. borrowing costs decline over our five-year forecast period (Figure 6), the spread should widen to around 150 bps, in line with the pre-GFC cycle.

Figure 6: MSCI All Property net initial yield vs. 10-year U.K. Gilt yield spread, by time period

Income growth will drive U.K. property returns

The lower spread between the risk-free rate and property yields will persist at least in the short- to medium-term, meaning the yield impact on capital growth will play a much smaller role relative to the previous cycle.

However, the day-one premium is not the full picture The demand-supply balance remains favorable for robust income growth in many parts of the market. Rent growth remained resilient through the downturn of 2022-2024 and rent growth has been positive in every single sector, particularly strong for prime assets. The supply overhang seen after the GFC is much less of a concern going into the new cycle, given limited development since the beginning of the pandemic in 2020 in the majority of property sectors.

The current real estate cycle will be radically different from the previous one, due to the current higher-for-longer yield environment vs. the lower-for-longer one that defined the previous cycle. Concurrently the rise in volatility and uncertainty across global financial markets makes this a challenging time for investors but also offers opportunity. Focusing on parts of the market that offer strong income growth from the onset will be key for outperformance.