The UK gilt market has a fragility problem. That might sound like an uncomfortable thing to say, but I think it is the honest starting point for any serious conversation about where UK fixed income goes from here. Yields on ten-year gilts have pushed back over five per cent – a level that, not long ago, would have seemed extraordinary. Today, it barely raises an eyebrow. That desensitisation worries me, because the underlying dynamics that got us here have not gone away.
The conflict and its inflationary consequences are the most immediate pressure points. UK rates markets have, in my view, reacted more honestly to the geopolitical situation than many other asset classes.
Credit spreads have remained relatively sanguine. Equities have bounced around but broadly held up. Gilts, particularly at the front end, have absorbed a meaningful repricing – and I think that repricing is largely justified. The Bank of England finds itself in an uncomfortable position.
Before the conflict, there may have been one or two cuts left in the cycle. Now, with energy prices elevated and the risk of second-round inflation effects rising, the Bank will not want to be seen repeating the mistake of being behind the curve, as it arguably was in the last hiking cycle. The hurdle for raising rates again is lower than many investors appreciate.
The critical variable is duration. If energy prices stabilise and the conflict resolves, the inflationary impulse fades and the Bank can hold. That remains a plausible outcome. But if this drags on, and there are credible voices suggesting the squeeze on energy markets could persist for some time, then domestic inflation becomes more embedded, and the Bank's hand is forced.
Markets are already beginning to price a more persistent inflation shock at the shorter end. Further out on the curve, that nervousness is visible too, though it has a different character: less about rate expectations and more about fiscal sustainability.
The fiscal dimension
The UK's fiscal position adds a layer of vulnerability that is hard to ignore. We recently saw a gilt syndication priced at the highest borrowing cost since 2008. That is not an abstract; it means the government is paying materially more to refinance existing debt and fund new spending.
At some level, that becomes unsustainable, though pinpointing exactly where is more art than science. What I can say with confidence is that it does not take a great deal more deterioration from here to get to somewhere uncomfortable.
The political backdrop adds to this. The gilt market will be highly vigilant about any shift in the fiscal stance that emerges from domestic political change. Markets have long memories – late 2022 demonstrated what happens when investors lose confidence in a government's commitment to fiscal discipline.
Any new political configuration would need to move quickly to reassure the market. Whether that reassurance would be believed is the harder question, and one that is genuinely difficult to answer in advance. The bond market tends to deliver its verdict quickly and without sentiment.
Sterling credit
Away from gilts, the sterling corporate credit market deserves its own honest assessment. I grew up in this market, and I say this with some regret: it has been in a slow structural decline. Sterling credit was once the natural home for long-dated, high-quality issuance – 20 and 30-year paper from quality borrowers, supported by robust demand from pension funds and insurers with matching long-term liabilities. That demand has largely gone. The average duration of sterling investment-grade indices has shortened markedly, from something closer to eight years not long ago to around five and a half years today.
The issuance base has narrowed considerably. For much of recent years, the market has been dominated by domestic names – UK banks, utilities, social housing providers. Depth and liquidity have declined relative to the euro market, which has grown significantly in size and now offers most international borrowers a more attractive funding proposition. When a large technology company issues a significant sterling deal, it genuinely breathes life back into the market but it does not signal a structural reversal. Those companies come to sterling when it suits them; it remains a secondary consideration to their dollar and euro programmes.
This matters for any business that is primarily UK-focused, with sterling cash flows and limited ability to raise debt in other currencies. For those issuers, a thinner sterling credit market means less liquidity, fewer investors and, potentially, higher funding costs. It is a quiet structural shift that has received far less attention than the decline of the UK equity market, but the implications are similarly worth understanding.
Iain Buckle is head of fixed income at Aegon Asset Management. The views expressed above should not be taken as investment advice.