Why bonds are back in the spotlight – and why it matters

Backdrop: When governments need to borrow money to fund expenses, they generally do so by issuing bonds. In the UK, government bonds are known as ‘gilts’. Each gilt will pay a regular amount of interest over the course of its life, which is called the coupon, with higher interest rates charged for bonds seen as ‘less safe’.

The amount an investor earns lending to the government on a 10-year gilt has risen sharply in recent months to 5%, a level not seen for years and a sign of investor unease. Likewise, the yield on a 30-year gilt is close to 6%, a level not seen since 1998.

Why are gilt yields rising?

Investors hate uncertainty, but the UK currently has it in bucket loads. The Labour party leadership contest is raising fears that the government’s already weak finances will be put under further strain should candidates promise to spend more in a bid to woo voters.

The Iran war is making things worse. Energy prices worldwide have risen sharply, and the UK is particularly vulnerable as it imports much of what it needs. This feeds through into higher costs for households and businesses. The result is that domestic inflation has risen notably.  As well as uncertainty, bond investors hate inflation as it erodes their returns. As a result, they demand higher compensation to hold gilts, which means higher yields.

Can the Bank of England help?  

The Bank of England (BoE) is in a very difficult position. It would like to cut interest rates because growth in the economy may weaken. Lower interest rates typically stimulate borrowing and reduce the level of repayments for businesses and households. A reduction in interest rates would also encourage consumers to feel more confident about spending, something else that could help the economy.

Bond investors also like it when central bank interest rates fall. This is because it makes the higher interest rates on their existing bonds more valuable.

Yet, in large part because of the energy shock, inflation is on its way up. Its current level of 3.3% is above the BoE’s 2% target. When inflation is this high, cutting rates (and encouraging more borrowing) will drive inflation even higher and investors will demand even more compensation in the form of higher gilt yields. Leave it too late to raise rates, and inflation could become de-anchored. UK inflation rose to 11.1% at the end of 2022, in part because the BoE was slow in raising interest rates.

What is the worst-case scenario?

If it continues, weaker economic growth and the recent spike in inflation could lead to stagflation. This would be the worst option for bond investors. Inflation erodes the value of existing assets, especially bonds. They will continue to demand higher yields to compensate for the higher risks and higher inflation. Because long-term bonds lock in a fixed interest rate for decades, these are the ones most vulnerable to performing weakly.

Are mortgage rates and bank borrowings affected by what goes on in the bond markets?

Definitely. In the UK, lenders tend to use gilt yields as a measure when setting fixed-rate mortgages. (In contrast the BoE base rate, often quoted in the press, reflects very short-term borrowing costs). Despite the 3.75% base rate, five year fixed-rate mortgages start at 4.5%.

An estimated 1.8 million fixed-rate mortgages expire every year. If the bulk of these are refinanced in the current environment, they are likely to be at significantly higher interest rates. Likewise, bank lending rates will also rise.

Does anybody benefit from higher bond yields?  

Savers are clear beneficiaries from rising bond yields. Cautious investors, especially those with a low risk tolerance such as workers nearing retirement, are receiving a government guaranteed return of over 5% on UK gilts.  These investors will be prioritising income over higher risk growth investments.

Cash saving rates in banks will also rise as base rate and bond yields go up.

Why do bond prices fall when bond yields rise?  

This is perhaps the single most important thing to understand about bonds. When bond yields rise, their prices fall and vice-versa.

As said, inflation fears have increased expectations that UK interest rates will rise.  Investors in gilts are therefore demanding a greater financial return to compensate them. This is also happening in the US and Europe. Higher inflationary fears have increased interest rate expectations. Higher inflation erodes the value of bonds, causing their prices to fall and resulting in higher bond yields.

Longer dated bonds are more risky than shorter ones because investors hold them for a longer period. This explains why 30-year gilts yields are usually much higher than shorter dated ones.

Do bonds still protect against volatility and market sell-offs?

Bonds have traditionally played a stabilising or ‘defensive’ role in investment portfolio. A common approach for investors has been the 60/40 split. This is where 60% is invested in shares for growth (but higher risk), with the remaining 40% invested in bonds for income and relative stability.

In the past, this balance often worked well. During periods of market stress, investors tended to move money out of shares and into bonds. This ‘flight to safety’ typically pushed bond prices up, helping to offset losses elsewhere.

However, this relationship has been less reliable in recent years. Events such as the pandemic and global conflicts have led to higher inflation and rising interest rates, which have put pressure on both shares and bonds at the same time.

In 2022, for the first time in decades, global bond and stock markets both fell. This was an exceptional period in the global economy, when a dramatic rise in inflation saw central banks increase interest rates rapidly in order to tackle it. This reduced the value of existing bonds.

So far in 2026, bond market returns have continued to lag behind stock markets. This reflects ongoing inflation pressures and the fact that interest rates have remained relatively high.

What does this mean for investors?

Bonds may still play an important role in a diversified portfolio, alongside other investments such as equities and cash. Not only will bonds typically provide investors with an income, but they may also help to reduce risk over the long term. This is because they are seen as a more stable and less risky alternative to equities, typically being less prone to market swings.

However, while bonds and equities historically move in opposite directions, this is not always the case. In periods where inflation is rising and interest rates are too, then bonds may move in the same direction as equities, creating more risk for investors. This highlights that investment outcomes are never certain, and investors could end up with less than they initially invested.

This doesn't remove the importance for investors of having a diversified portfolio, however, but it does highlight how asset classes can work differently depending on the economic environment.