Investor Insights: Are UK Gilts Attractive Again After the Sell-Off?

The sell-off in UK government bonds has been less like a straightforward inflation panic and more like a market demanding an additional political risk premium. As in 2022, the selloff in gilts has come amid a global bond rout, but the UK has again been punished more heavily than others due to political and fiscal worries.

Long-dated gilt yields have climbed sharply in recent weeks with the 30yr gilt yield at a 28-year high as investors grapple with two overlapping risks: first, the possibility that escalating tensions in the Middle East could persist and not just push energy prices materially higher but lead to a second-order impact on inflation; second, growing concerns that the emerging Labour leadership struggle could weaken fiscal discipline just as Britain’s debt servicing costs remain elevated.

But after the move higher in yields, investors should ask a more important question: are gilts now beginning to look attractive again? There is a growing case that they are.

The market is pricing a lot of bad news

The first phase of the gilt sell-off was relatively straightforward. Rising oil prices and fears of renewed inflation forced markets to reassess the likely path for Bank of England rate cuts.

If energy inflation feeds through into headline CPI, the BoE becomes more cautious. That pushes up front-end yields.

But the second phase has been more political in nature since the 6 May elections in England, Scotland and Wales heaped pressure on the prime minister, Keir Starmer.

The prospect of a Labour leadership contest — with figures such as Andy Burnham and Wes Streeting increasingly challengers to Starmer — has introduced fears that fiscal policy could loosen further, particularly if leadership contenders begin competing on spending promises ahead of an election cycle.

That matters because the UK remains unusually sensitive to shifts in market confidence.

Britain runs persistent fiscal deficits, has relatively short average debt maturity compared with some peers once inflation-linked debt is accounted for, and already faces elevated debt servicing costs after the inflation shock of 2022-23.

Investors therefore do not just price inflation risk into gilts — they price political credibility. And that credibility premium has clearly deteriorated.

But how much higher can yields realistically go? This is where the investment case becomes more interesting.

The UK is not facing a mini-budget style crisis.

There is currently no sign of unfunded tax cuts on the scale seen during the September 2022 United Kingdom mini-budget shock. In fact, even leadership challengers inside Labour are still publicly committing themselves to fiscal rules. Importantly, Andy Burnham chose to go on Bloomberg to say that not only would he stick to the current fiscal rules, he would not exempt defence spending from this paradigm. This could be important - given Burnham is the hot favourite to win any leadership race - in the context of the current level of risk premia priced into gilts.

That distinction matters enormously. Markets are nervous about fiscal drift — not outright fiscal abandonment - the UK is not at risk of defaulting on its debts. It's just that it may need to print more and borrow more to get by - the prospect of which bond vigilantes have been swift to punish, even if it's not what transpires.

At the same time, long-term gilt yields are already embedding a fairly aggressive combination of assumptions:

• structurally higher inflation

• elevated term premia

• political instability

• slower growth

• slower BoE easing

That is a difficult combination to sustain indefinitely.

Historically, gilt markets tend to overshoot during periods where inflation fears and political fears arrive simultaneously. Once one of those fears begins to fade, yields can retrace surprisingly quickly.

And there are several reasons why that could happen over the coming months.

The growth backdrop still argues for lower yields

The UK economy is hardly booming: Consumer demand remains patchy, the housing market is fragile, and business investment continues to struggle against weak productivity growth and high financing costs. Critically today's labour market report showing plunging payrolls and rising unemployment whilst wage growth cools argues for the Bank of England to remain on pause.

If higher energy prices start to squeeze households again, the likely outcome is not necessarily sustained inflationary overheating — it may instead be weaker real growth. That matters because markets eventually return to fundamentals.

A structurally weak growth economy typically struggles to sustain very high real yields for long periods.

Meanwhile, pension demand for long-duration assets remains substantial, albeit there is a structural problem with the declining defined benefit liability matching bid for gilts that's sustained them for decades; insurance buyers continue to require high-quality sovereign collateral, and overseas investors may increasingly view gilts as relatively attractive versus European government bonds once currency effects are considered.

In other words, there is a growing possibility that gilts are moving from being politically toxic - uninvestable I've heard from some, to a clear point where value starting to emerge.

Rate cuts not hikes

As I have consistently argued the market is mispricing the future monetary policy path for the Bank of England. I believe the data points to the need for rate cuts rather than hikes. Here is the excellent Frank Flight of Citadel: "Importantly however the better growth outlook continues to look broadly consistent with a more dovish BOE policy path than priced. Whilst inflation will accelerate due to the energy shock, the underlying trend in the policy relevant data continue to point to rate cuts. Using our policy relevant data framework, which includes 15 different inputs across various inflation, inflation expectations, wages, vacancies, hiring and labour market proxies, we estimate a risk neutral policy outlook consistent with 50bp of rate cuts over the policy horizon, vs 2y2y Sonia which currently prices over 50bp of hikes, implying a 100bp residual risk premium."

What investors should watch now

For investors considering gilts, the next few months will likely hinge on four key signals:

1. Oil prices and shipping disruption

If Middle East tensions fade or energy prices stabilise, inflation fears could ease rapidly.

2. Labour’s fiscal messaging

Markets will closely watch whether Labour leadership contenders continue backing fiscal rules or begin signalling materially looser spending plans. The mood music is that they understand they need to stick to the rules.

3. Bank of England language

If the BoE starts emphasising growth weakness over inflation persistence, markets could quickly revive rate-cut expectations.

4. Gilt auctions and foreign demand

Strong auction coverage or improving overseas participation would suggest buyers are returning at these yield levels. Important to note that the DMO is cutting maturities, which will support the long end of the curve (ie lower rates). Here is Flight of Citadel again: "The 2026-2027 financing remit implies planned gross gilt sales of £246.2bn, of which a total of £171bn will come via conventional and syndicated issuance in the short and medium part of the curve, representing 69.5% of total issuance, up from around 55% on the eve of the 2022 gilt crisis."

The bigger picture

For long-term investors, the key point is that yields are now starting from much more attractive levels than they were for most of the post-financial crisis era. The income from yields is at levels where stocks are coming under pressure again. And unless investors believe Britain is heading towards a full-blown fiscal credibility crisis — which currently still looks unlikely — there is a reasonable argument that risk premia have become somewhat excessive.

That does not mean volatility disappears. But it does suggest that, after a painful sell-off, UK government bonds may increasingly offer some value with yields this high. That said I remain of the belief that we have to contend with rates and inflation settling higher than it would have done before the Iran/Labour dramas.

Markets assume Burnham will risk fiscal credibility to win support - assuming he's already won the support of the Labour party (which polls suggest he has easily) there's significant cost to a leftwards lurch and there's a great deal more strategic logic to getting the bond market on side, lower bond yields (and therefore borrowing, creating more headroom) and nixing the fiscal credibility doom loop.

Here's our 3 scenarios for gilts based on the current macro setup