By David Milliken and Yoruk Bahceli
LONDON, May 12 (Reuters) – Intense pressure on Prime Minister Keir Starmer is driving up British government borrowing costs – but the political uncertainty is by no means the only factor making Britain’s bond yields the highest among major advanced economies.
Yields on 10-year government bonds – which determine how much the government will pay for future borrowing – on Tuesday hit their highest since 2008 at 5.13%.
“There’s a lot of fear in the price with gilts,” said Gordon Shannon, a partner at investment firm TwentyFour, which manages 23.5 billion pounds ($32 billion) of fixed income assets.
Most of the potential contenders to succeed Starmer – who came to power in July 2024 with a large parliamentary majority – are likely to want to borrow more, with the possible exception of health minister Wes Streeting, Shannon said.
Greater Manchester mayor Andy Burnham – who would first need to be re-elected to parliament to succeed Starmer – might borrow an extra 50 billion pounds over five years – around a 12% increase on current borrowing plans – if, as he has suggested, defence spending was exempted from existing finance constraints, Shannon said.
MEMORIES OF LIZ TRUSS SHOCK REMAIN FRESH
Still weighing on British bonds’ international appeal is Liz Truss’ brief tenure as prime minister. Her attempt to slash taxes caused long-dated gilt prices to tumble and forced the Bank of England to step in to halt a firesale by pension funds as ‘bond vigilantes’ circled.
Kevin Thozet, an investment committee member at the French investment manager Carmignac, said investors had charged Britain some “so-called moron premium” in the aftermath of the market crisis that Truss’ mini-budget unleashed, “and that could well be the kind of environment we’re heading into”.
But TwentyFour’s Shannon saw no chance of a repeat of such a sharp selloff, saying British politicians who wanted to borrow more now knew they needed to trail those plans in advance and pull back if there was an adverse market reaction.
Britain’s 10-year gilt yields of 5.12% compare with 4.45% in the United States – where growth is more robust – and 3.10% in Germany – perceived as more fiscally disciplined.
Since the start of the year, they have risen by 0.64 percentage points, more than double the increase in 10-year bond yields in the U.S. and Germany.
Rising gilt yields only affect the cost of newly issued debt, so the impact on government budget plans is not immediate.
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But Britain’s budget watchdog estimates that every percentage point rise in yields will cost the government an extra 15 billion pounds a year in debt interest by 2030. To meet its goal of a balanced current budget by 2029/30, it only has 24 billion pounds of leeway.
UK SEEN AS MORE INFLATION-PRONE
Britain’s higher borrowing costs cannot be put solely at the door of politics, said Alexandra Ivanova, a fund manager at Invesco, which holds around $500 billion in bonds.
“I need to remind investors of ‘Finance 101’,” she said. “You need to think what you’re getting paid for: liquidity risk premium, political risk premium, the term premium, inflation risk premium … and in the case of gilts, I think each one of those elements tends to be higher than anywhere else.”
Given all these factors, UK gilts did not appear a bargain, even with their higher yield, she said.
Inflation risk is the easiest to grasp. The U.S.-Israeli war with Iran has pushed up oil and natural gas prices by around 50% since the end of February.
Britain relies on natural gas imports and the Bank of England forecasts that inflation – which erodes the value of bonds – could exceed 6% early next year if energy prices rise and are slow to fall. Before the conflict, it was forecasting that inflation would return to its 2% target.
Inflation in the euro zone had been back to target before the conflict but it had been stickier in Britain, reflecting rises in regulated utility prices last year and higher wage growth since the COVID-19 pandemic.
Financial markets now price in a rise in the benchmark BoE lending rate to 4.5% by February 2027 from 3.75% now, compared to forecasts of one or two cuts before the conflict. Many economists are more sceptical, however, given that the weak outlook for British growth will also curb inflation.
UK GILTS MORE VOLATILE THAN OTHER SOVEREIGN BONDS
A more subtle reason for higher gilt yields is the fact that British government bonds are more volatile in price than U.S. or German debt.
For much of the past 20 years, British pension funds and life insurers bought 30-year gilts to match their long-term liabilities.
But companies’ shift away from defined-benefit pension schemes has ended that process. Gilt buyers are now more often foreign hedge funds, said Nicolas Trindade, senior portfolio manager at BNP Paribas Asset Management, and these are more price-sensitive and investing on much shorter time horizons.
The risk of big day-to-day lurches in turn makes some investors demand a bigger yield.
Some investors also blame the Bank of England’s programme of bond sales – currently running at 70 billion pounds a year – for pushing up gilt yields.
Shannon thought that, over the medium term, the political risk premium would narrow, but said it was harder to judge the other elements.
But for now, political uncertainty looms large.
“You need various foreign investors to be interested. And turning over prime ministers isn’t what people want to see.” ($1 = 0.7394 pounds)
(Writing by David Milliken; Editing by Kevin Liffey)