UK Gilt Yields Rise To Highest Levels Since 1998, But What Does This Mean?

Yesterday it was reported that yields on UK government bonds, known as gilts, have climbed to their highest levels since 1998.

The 30 year gilt yield now sits at 5.40%, ,whilst the 10 year gilt has gone up to 4.84%. This is a direct reflection of investor confidence in the UK’s finances and is usually a signal of huge uncertainty.

What Are Gilts?

Gilts are UK government bonds that are floated on the London Stock Exchange. They are seen as a low-risk investment because they are government backed, meaning your returns are secured.

When you buy a gilt, you’re essentially lending money to the government for interest. The way these are paid depends on the type of gilt you own, the types include:

Conventional gilts

When you buy a conventional gilt, the government agrees to pay you a fixed cash payment (coupon) every six months until the term ends. Once this happens, you’ll get the final payment and the return of the principal amount you put in.

Conventional gilts are currently sold for £100 each.

For example, say you buy £1000 worth of conventional gilts today at the 30 year rate of 4.84%.

The £1000 is known as the principal, since that is your original cash investment.

Under the new interest rates, you will be paid back 4.84% of £1,000 = £48.40 every year, or £24.20 every 6 months. This will happen for 30 years until 2055 (when the term ends).

This £48.40 payment is known as the coupon rate, which is fixed on the day that you buy the gilt and committed for the entire term. What that means is that you are guaranteed to be paid no more or less than £48.40 interest per year on your 10 gilts.

At the end of the gilt’s term (30 years), you will get your final payment of £24.20 plus your original £1000 back.

Over 30 years, with £48.40 paid back every year, you will have made £1,452 back in interest and have a total of £2,452 once the £1,000 principal has been paid back.

Index-linked gilts

Index-linked gilts work slightly differently. These were adopted in 1981 as a way to help people keep up with inflation.

Unlike conventional gilts, which operate on a set coupon rate for the whole term, index-linked gilts adjust the interest based on the UK’s Retail Prices Index (RPI) but with a slight lag.

As with conventional gilts, this is paid every six months, but the amount will go up and down based on the RPI.

Why Do Gilt Yields Go Up And Down?

Like with all bonds, the price of gilts can go up and down due to supply and demand. Gilts can be sold on secondary markets, meaning investors can buy and sell them based on their yield.

There are two principles at work here:

The price: The value of buying a gilt (which can go up and down)

The yield: How much money you earn from a gilt, paid as a percentage of what you paid for it (coupon) and fixed over a period of time.

Like with most things, when more people want to buy more gilts, the price of them goes up with demand.

Say you originally lock in for 5% coupon on a £100 gilt, you would earn a £5 coupon back every year.

But when the price of a gilt goes up to say, £110, you will still earn your £5 coupon on it. However, this is no longer 5% of the total, but about 4.55%.

What that means is, you actually are earning a lower interest on the value of the total because the price of it has gone up.

This also happens in reverse.

Say demand goes down and the new gilt is now being sold at £90 with a £5 coupon per year, this becomes a yield of 5.56% instead of 5%. This can encourage more people to buy in due to the more appealing rate.

What Causes Gilt Yields To Go Up and Down?

There are a number of reasons that gilt yields might go up and down that sit outside of supply and demand. These include:

Interest rates

If the Bank of England cuts interest rates, gilts with higher yields become more in demand. This is because they become more appealing against standard savings rates.

As demand for them goes up, this increases their price and lowers their yield.

However, if the Bank of England raises interest rates, new gilts are issued with higher yields, making existing gilts with lower yields less attractive.

As demand for them drops, this lowers their price and increases their yield.

Inflation

If investors are expecting inflation to rise, they will want investments with higher yields that can help them battle inflation.

The price will then have to go down in order to increase the yield and make them seem more attractive.

Increased Government Borrowing

When the government wants to borrow more money, they will issue more gilts – which increases supply.

If demand is lower than the new supply, the price goes down, which pushes the yields up – making them more attractive.

Additionally, increased government borrowing is usually seen as a risky move by investors, so they will want to see higher yields to compensate for this risk.

Economic Uncertainty

In periods of economic uncertainty, gilts are seen as a safe bet. This could drive demand up, causing the price to go up and the yield to go down.

In periods of economic growth, investors might be more comfortable with riskier investments like equities, bringing demand and price down and increasing the yield.

Why Are Rising Gilt Yields Bad?

As someone buying yields, the higher yield isn’t necessarily a bad thing in terms of money in your pocket, but it isn’t a great sign economically.

Higher yields paid out by the government mean it’s more expensive for them to borrow money. This can have a negative effect on public spending on areas like schools, healthcare and other public sectors.

The higher yields are also a signal that long-term interest rates on loans like mortgages are unlikely to drop anytime soon. This makes it more expensive for people to borrow money, which can increase monthly payments and decrease their spending power.

Usually, higher yields are seen as a sign of uncertainty by investors. When investments seem riskier, investors want to be compensated by higher returns to combat this. This sentiment can directly impact perception of the UK economy, which can impact international trade, the value of the pound and foreign investment.

Rising Gilt Yields: What Does It Mean?

Rising gilt yields can be a signal of economic uncertainty and what it means in the short term, is that the government may struggle even more to fill the £20bn ‘black hole’ that they inherited from the Tories.

However, the UK isn’t alone in its rising yields. The US and German yields are also up, showing general hesitancy for investors to lend to governments. Ultimately, economists will be looking closely to understand how the Labour government will work to boost the economy, keep the pound strong and borrow less – all in the next few years.