Worries on gilts point to wider bond market vulnerabilities

Rising public debt adds pressure while increased hedge fund trading opens up new fragilities.

The dismal combination of geopolitical tensions, above-target UK inflation and Sir Keir Starmer’s wobbly leadership has caused gilt yields to surge to what many describe as landmark levels. Yet a 10-year gilt yield of more than 5 per cent is far from shocking if you look back beyond the period since the financial crisis of 2007-09.

What has changed in recent years and what does justify nervousness now is that there has been a steady erosion of the resilience of government bond markets in advanced countries in the face of rising interest rates, not least in the UK.

Part of the British problem is the relentless rise in public debt, which has gone from 28.3 per cent of GDP at the start of the century to close on 100 per cent today. The financial crisis, the Covid pandemic and the energy shock played a large part in that.

The upward pressure is now reinforced by demographics. In its Fiscal Risks and Sustainability Report last year, the Office for Budget Responsibility estimated that on current policy settings the rising costs of healthcare and other age-related expenditures could cause public debt to top 270 per cent of GDP by the early 2070s. The report also stated that the UK government faced the third highest borrowing costs of any advanced economy other than New Zealand and Iceland.

All this implies that the government’s ability to respond to future shocks is severely impaired. And as in most other advanced economies the problem of funding is exacerbated by a marked shortening of the maturities of new debt, calling for heavy debt redemptions every year. The average maturity of the UK’s public debt stock has hitherto been one of the world’s longest.

This change increases rollover risk as the fiscal position becomes more sensitive to increases in interest rates. That is, shorter-maturity gilts adjust more quickly to changes in the Bank of England’s policy rate relative to longer-maturity gilts.

Surging interest rates are not uniformly bad news because they help shrink the present value of future defined benefit pension liabilities as actuaries apply higher discount rates to those costs in their valuations. Yet defined benefit pension schemes are themselves shrinking, which reduces demand for gilts and pushes up government borrowing costs. The OBR estimates that the share of gilts held by insurers and pension funds has fallen steadily from about two-thirds in 1998-99 to about one-third in 2023-24. Overseas investors and the Bank of England, through its asset purchase facility, have become the largest and second largest holders of gilts at 31 and 29 per cent respectively.

This has worrying implications for market resilience because while central bank reserve managers have been reducing their holdings of sovereign bonds, the most significant foreign investors are now price-sensitive hedge funds. These chiefly pursue highly leveraged trading strategies facilitated by short-term financing known as repos. Much of this is related to the basis trade where hedge funds purchase gilts and sell gilt futures contracts, taking advantage of small price differentials.

Pablo Hernández de Cos, general manager of the Bank for International Settlements, has pointed out that the greater presence of such non-bank investors in sovereign bond markets increases the likelihood of sharp non-linear yield spikes, giving rise to so-called snapback risk. The larger hedge funds borrow amounts equal to or higher than the market value of the collateral provided — that is, without any discount or haircut to protect the cash lender.

Hedge funds’ relative value strategies, Hernández de Cos argues, are highly vulnerable to adverse shocks in funding, cash or derivatives markets. Margin calls can trigger unwinding of their trades, contributing to destabilising deleveraging spirals.

In a new G30 report Agustín Carstens, Stijn Claessens and Klaas Knot — pillars of the global central banking establishment — complain hedge funds are trading positions with exposure equivalent to 200 times their own money put into the trade or with haircuts as low as 0.50 percentage points and sometimes negative. They conclude that these and other fragilities are not only prone to tipping core sovereign bond markets into dysfunction but pose a major systemic threat to the global financial system.

If so, a 10-year gilt yield of just over 5 per cent is scarcely a bargain. And longer-term pressures on public debt suggest politicians are all too likely to seek a solution in inflation or financial repression whereby they impose below-market interest rates on investors.