Some of the top asset management giants from Wall Street have even directly warned that one of the most popular bond asset trades in a century now requires nerves of steel to hold.
According to Zhitong Finance, as volatility surged and this severe fluctuation once exceeded that of the stock market, British government bonds (also known as ‘gilt-edged securities’), which have been favored by global investors for nearly a century, are now facing a severe test of their appeal. Some top asset management giants from Wall Street have even directly warned that one of the most popular bond asset trades over the past century now requires nerves of steel to hold. Once considered ‘cheap and safe,’ British gilt-edged bonds have now become high-volatility assets amid Middle Eastern conflicts, fiscal concerns, and changes in market structure.
During the renewed Middle Eastern war that began at the end of February, the British government bond market was more volatile than its European and American counterparts, and even after a preliminary ceasefire agreement was reached this week, volatility remained high. Since early March, the yield on British two-year government bonds, which is particularly sensitive to geopolitical news, has fluctuated by at least 10 basis points over 12 trading sessions, marking the most unstable gilt trade period since the UK government’s credibility crisis in 2022.
This intense volatility has prompted Wall Street asset management giants such as Vanguard International and Royal London Asset Management to adopt a more cautious stance toward British government bonds. Other fund management institutions, including Insight Investment and M&G Investments, have also warned that volatility may remain elevated for an extended period.
Severe instability in British gilt-edged bonds: ‘The most crowded trade’ undergoes major reshuffling.
“The UK has recently been the market most exposed to this kind of high volatility and exceptionally sharp movements driven by geopolitics,” said Ales Koutny, head of international rates at Vanguard. He has unwound his aggressive bet on UK bonds outperforming continental European bond assets. “We still believe UK assets look very cheap, but now you need greater resilience to withstand this volatility.”
As shown in the chart above, the volatility of British government bond yields far exceeds that of comparable markets—these violent fluctuations are making some investors cautious about their exposure to British government bonds.
Before the outbreak of the Iran war, British government bonds had become one of the most crowded trades in the fixed-income space. Investors had anticipated that the Bank of England would opt for a rate-cutting cycle due to a weakening labor market, which would inevitably lead to a significant decline in British yields. The new round of geopolitical conflicts in the Middle East and the resulting surge in energy prices disrupted these optimistic expectations, forcing investors to now consider the possibility of the Bank of England resuming interest rate hikes.
“For roughly the past year, British government bond assets have appeared particularly cheap,” said April LaRusse, head of investment specialists at Insight Investment. “You’re now facing a situation where suddenly everything we’ve been focusing on has come under serious question.”
LaRusse pointed out that due to the openness of the UK economy, significant fiscal and trade deficits, and reliance on imported energy, it is more vulnerable to inflation and stagflation shocks than other developed countries.
As shown in the chart above, British government bond yields are the highest in developed markets—the yield on 30-year British government bonds has remained above 5% for more than a year.
UK government bonds continued to decline on Friday, erasing some of this week’s gains. Yields rose by approximately 4 basis points across the curve, with the 10-year yield hovering just below 4.80%. During the height of volatility in March, the yield had surged to an astonishing 5.12%.
“Over the past three to four months, this has been one of the most favored sovereign bond markets,” said Craig Inches, Senior Head of Rates and Cash at Royal London Asset Management. “In our global bond funds, we have maintained exposure to the UK market, but due to the heightened volatility, we are now keeping our risk exposure at a relatively low level.”
Challenges Facing the UK Economy: Fiscal Uncertainty, Structural Changes in the Market, and Political Risks
Inches warned that although geopolitical tensions have altered the fundamental pricing dynamics in the bond market, concerns over the UK’s fiscal outlook have made its sovereign debt market more prone to sharp fluctuations. In 2022, deficit fears were a key driver behind the collapse of UK gilts triggered by the tax-cutting and spending plans of then-Prime Minister Liz Truss’s administration.
A bond fund that achieved strong positive returns during last month’s record sell-off in the global government bond market, driven by ‘stagflation’ expectations catalyzed by the Iran war, is betting that the yield curves of global government bonds will steepen as countries implement populist-oriented expansionary fiscal policies to cushion the impact of energy shocks. In other words, as ‘developed country governments spend to stabilize public sentiment,’ the bond market may soon begin to demand a price — particularly through an increase in the ‘term premium’ metric, which could drive global long-term bonds into a ‘steepening storm,’ triggering a sustained rise in yields for 10-year and longer-dated government bonds.
Guillaume Rigeade, Co-Head of Fixed Income at Carmignac, the French asset management firm managing the fund, stated in a recent media interview that as economies absorb the shock to growth, governments are likely to respond with more aggressive fiscal stimulus measures — which will undoubtedly push the term premium significantly higher, thereby substantially increasing yields on sovereign bonds with maturities of 10 years or longer. The 10-year U.S. Treasury yield, often referred to as the ‘global benchmark for asset pricing,’ if driven higher by fiscal stimulus-induced term premiums, will inevitably lead to a new wave of valuation collapses across high-yield corporate bonds, tech stocks, and cryptocurrencies, among other highly sought-after risky assets globally.
According to compiled performance comparison data, Carmignac’s bond fund delivered a return of 0.5% in March, while the Global Government Bond Index plummeted by 3.4%. This performance ranked second among 282 flexible bond funds in Morningstar Direct’s euro-denominated category.
Recently, UK government bonds have traded more like Italian sovereign debt did during the Eurozone debt crisis years ago, with investors typically viewing the latter as significantly riskier compared to ultra-safe assets such as German bonds. Based on compiled data, UK and Italian bonds exhibited similar performances over the past month, with both returning -0.2%, though UK gilts underperformed slightly.
Beyond unsettling investors, persistently high volatility is also impacting the broader UK economy. The sharp swings in interest rate swap markets prompted lenders to withdraw mortgage products, leading to a significant drop in housing demand in March. This turbulence has further complicated the UK government’s fiscal planning and created uncertainties for corporate financing, as businesses may become reluctant to issue bonds as a result.
However, other factors are also at play behind these fluctuations. As a relatively small sovereign bond market, the volatility in the UK market can appear disproportionately amplified when compared to larger and more liquid bond markets. At the same time, shifts in demand structures have made UK gilts more vulnerable to sentiment swings from relatively less stable investors, such as hedge funds, which often leverage borrowed funds to enhance returns. Meanwhile, demand from traditionally stable buyers, such as pension funds known for their long-term and prudent investment strategies, has declined.
“Over the past five years or so, the structure of our core government bond market has undergone significant changes,” said Andrew Bailey, Governor of the Bank of England and Chair of the Financial Stability Board, on Thursday. “There is indeed more leverage in the market, and pricing tends to be more volatile as a result.”
The next major test will come in May’s local elections, which are increasingly shaping up to be a particularly tough challenge for Prime Minister Keir Starmer’s governing party. Last year, Starmer faced calls from within his Labour Party to step down, and the prospect of a potential leadership contest looms large over global gilt investors, who remain acutely aware of the 2022 crisis that led to the resignation of former Prime Minister Liz Truss.
Overall, these risks imply that global ‘fast money’ strategists from leveraged hedge funds and similar institutions may adopt a more cautious stance toward the UK bond market.
“There is indeed a kind of semi-permanent risk premium at play here,” said Andrew Chorlton, Chief Investment Officer of Fixed Income at M&G. “It is still paying the price for events that occurred under a completely different government and policy agenda.”