- Sticky inflation, ever-increasing sovereign debts in the West and competition for capital are all driving up government bond yields
- Confusion over central bank policy and the future trajectory of interest rates is a further complication
- The 10-year gilt yield is seen as the UK’s risk-free rate and any other investment should return more than that to compensate for the additional dangers
- The higher the gilt yield goes, the less inclined, or obliged, investors may feel to pay up for alternative asset classes, such as shares (and vice-versa)
“The 2-year gilt yield is seen as a summary of financial markets’ views as to where the Bank of England base rate may go next, on the principle that it takes 18 to 24 months for changes in the headline cost of borrowing to filter through to the economy and consumers’ pockets. But from an investment point of view it is the yield on the 10-year issue that really matters, while economists may look at the 30-year paper as well, to judge whether inflation expectations remain anchored and the nation’s finances are healthy (or not),” says AJ Bell investment director Russ Mould.
“The 2-year gilt is flagging further interest rate increases, the 10-year gilt yield now exceeds the FTSE 100 dividend yield by nearly one-and three-quarter percentage points, and the 30-year yield stands at its highest mark since 1998 as markets fret about rising government borrowing and its affordability.
“One argument is that the rise in bond yields is not bad news, but good news, because it is a logical result of healthy economic growth rates, especially in nominal terms. It may also represent a return to normality after the crazy days of the 2010s and early 2020s, when headline interest rates and benchmark bond yields were near zero. That implied a cost of money, and time, of almost zero, which made little real sense.
Source: LSEG Refinitiv data
“However, consumers, companies and investors could all still be impacted, albeit in different ways:
- Credit card, mortgage and auto loan interest rates will rise if bond yields rise, as the lenders seek to preserve loan book margins and manage their risk.
- Corporate profits could take a hit if a higher cost of debt crimps demand and investment.
- That in turn could affect equity valuations and headline stock market indices, which could also falter if higher bond yields persuade investors to seek income from gilts rather than equities and, in theory, take less risk in the process, at least in nominal terms. Higher bond yields also mean higher discount rates in discounted cash flow (DCF) models, and thus lower theoretical equity valuations, especially for companies whose strongest years of profit and cash generation may be some time in the future, such as technology and biotechnology companies.
“Higher interest rates and bond yields in themselves do not necessarily spell the end of an equity bull run.
“For now, higher bond yields are not unduly inconveniencing the FTSE 100, which still trades close to all-time highs, within touching distance of the 11,000 mark and up by more than 100% from the Covid-19 lows of March 2020.
Source: LSEG Refinitiv data
“But in the end, weight stops trains and racehorses and higher returns on cash and fixed-income securities slow down stock markets – it is a matter of degree.
“The FTSE 100 has done a good job of sweeping aside increases in the Bank of England base rate and the 10-year gilt yield from generational lows, helped by benign inflation, good earnings growth, takeovers, and generous cash returns.
“Increases in Bank of England base rates, and bond yields, could upend many of these calculations. In a worst case: earnings growth could take a hit if higher borrowing costs cool consumer spending and corporate investment; takeovers could dry up if the cost of any debt used to fund them means such deals are no longer attractive; and higher yields on bonds make the yield on equities look less appealing, especially on a relative, risk-adjusted basis.
“The FTSE 100’s forecast dividend yield for 2026, based on consensus analysts’ forecasts, is 3.5%. The 10-year gilt yield is now 5.22%, so that one-point-seven-percentage-point gap may be enough to persuade some investors, especially risk-averse ones, to turn to bonds for income.
“The FTSE 100 is also on track to return £46.5 billion via share buybacks, or 1.8% of its stock market value, while takeovers for members of the index could reel in another £46.8 billion for shareholders, to take the total cash yield from the index to 7.1%.
“That exceeds the 10-year gilt yield, but by a diminishing amount.
“Investors must then assess the potential for share price gains and more takeovers, dividends and buybacks, against the risk of share price falls, cancelled deals and cuts to dividends and buybacks, as well as against the relative certainty offered by gilts, where the bond is redeemed at its issue price and coupons are paid at pre-set times in pre-set amounts in between.
Source: Marketscreener, analysts' consensus forecasts, company accounts, LSEG Refinitiv data. *As % of FTSE 100 stock market capitalisation.
“Meanwhile, sticky inflation fears, thanks to energy in particular, mean the 2-year gilt yield now comfortably exceeds the Bank of England base rate. This suggests bond markets think that three or maybe even four one-quarter-point interest rate hikes are coming from the Bank of England in the next 24 months, even if this feels like it would be a dramatic tightening – and one that could do a fair degree of harm to the UK’s already modest economic momentum.
Source: LSEG Refinitiv data
“Meanwhile, the 30-year yield stands at a mark not seen since 1998, thanks to worries over UK government borrowing and an interest bill that chews up a tenth of annual taxation income, exceeding defence spending in the process.
Source: LSEG Refinitiv data
“The good news here, at least, is that the UK has an average maturity of more than 13 years on its £2.9 trillion stock of gilts, and barely a sixth mature in the next three years. Those bonds are likely to be replaced by bonds with a higher coupon, given where interest rates and bond yields are now, so they will add to the interest bill, but not as dramatically as refinancing needs may add to America’s debt woes, where half of its $32 trillion of Treasuries mature by the end of 2028.
“In this respect, Andy Burnham and John Healey have a little more room for manoeuvre than Donald Trump and Scott Bessent.
Source: UK Debt Management Office data, US Congressional Budget Office data
“The test now is whether higher yields on government bonds tempt portfolio builders to take less risk and pay lower valuations and prices for riskier assets, because they may feel they do not need them quite so badly.
“Tales of investors ‘going to cash’ are entirely misleading. If someone sells, someone still must buy and give away their cash in exchange. The shares do not disappear, so there is no wholesale movement from one asset class to the next. Instead, there is a relative movement in intent and desire, as reflected in the higher or lower returns that the investor is prepared to accept in return for exposure to that asset class, be it cash, bonds, shares, or something else.
The risk-free rate
“The yield offered by a government-issued bond is usually seen as the risk-free rate for investors in that country because, in principle, the government will not default on its liabilities. It will always be good to make the interest payments (or coupons) on time and return the initial investment (or principal) once the bond matures, even if it must print money to do so.
“Bear in mind that the yield on the bond will differ from the coupon, or interest rate, at its time of issue. This is because the bond’s price will move over time. The running yield of the bond is calculated by dividing the annual coupon by the current price and expressing that as a percentage. The yield to maturity will adjust for any capital gain or loss after the purchase of the bond since it will usually be redeemed upon maturity at its issue price.
“The last time the UK defaulted was 1672 and the Stop of Exchequer under King Charles II and as such as the 10-year UK government bond, or gilt, is seen as the risk-free rate for UK investors.
“The 10-year gilt is yielding 5.22% at the time of writing. This is therefore the minimum nominal return on any investment that any investor should accept, since it is seen as risk-free (despite the tiny chance the UK does default, or the other challenges posed by movements in interest rates and inflation).
“Any other alternative investment carries more risk, so the investor should demand more from them:
- Investment-grade corporate bonds should yield more than government bonds because companies can and do go bankrupt and management teams can do silly things.
- High-yield (or junk) corporate bonds should yield more than investment grade bonds because these firms are more indebted, and the risk of bankruptcy and default is higher.
- Shares should offer the prospect of higher total returns than junk debt because share prices go down as well as up, while a junk bond will offer pre-determined interest payments and return of the initial investment if all goes well.
“The returns demanded by an investor to compensate themselves for the (additional) risks involved will therefore, in theory, move relative to the gilt yield and that in turn will be influenced by central bank-approved interest rates.
“If a central bank is raising interest rates, then the yield on existing government paper will look less attractive. Investors will sell them and look to buy newly issued gilts, which will have to come with a higher yield to attract buyers and help the government fund its spending needs.
“This increase in yields on government debt means the returns that investors should demand from other, riskier options, should also increase. This means a higher yield on newly issued bonds or paying a lower price for existing bonds (as a lower price means a higher yield for bonds, just as it does for shares).
“For shares, it means paying a lower valuation, or multiple of earnings and cashflow, and perhaps demanding a higher dividend yield (which is achieved by buying at a lower share price).
“Remember that the total return from a share is determined by capital return plus dividend yield and the capital return will be, in crude terms, the function of both earnings growth and the multiple paid to access that earnings growth.
“In its simplest form, this can be seen in the price/earnings (PE) ratio. Earnings will go up (or down), depending upon the business cycle and the company’s target industry and acumen. The price, or multiple, paid can be affected by many things, including the company’s finances, managerial competence, and governance, as well as the predictability and reliability of its operations and financial performance.
“Interest rates will have a big say, too. If rates and gilt yields are rising, investors may feel less inclined or obliged to take more risk with shares and other asset classes if safer options are offering better returns, at least on a pre-inflation basis. As a result, they may decide to pay lower prices and multiples – a lower P for the E – and that is why stock markets can slide as rates rise, especially because someone still must hold the shares. They do not just disappear, so the new owner must make a judgement on what they are worth.
“For property, the same calculation will apply – the rental yield will be benchmarked against the safer options, in nominal terms at least, of cash and gilts and other bonds. New buildings will need to offer a higher rental yield to attract buyers, and that often means lower property values.
The discount rate
“There is another way in which interest rate movements affect share prices and equity valuations and this is the more complicated version of the PE ratio. This is the discounted cash flow (DCF) calculation.
“Such a valuation approach is not necessarily suitable for, or at least easy to apply to, all companies, as some have business models and revenue and cash flow streams that are very volatile, or at least cyclical.
“DCFs tend to be used for companies that have relatively predictable cash flows, or long-term secular growth prospects. They are also used for young, early-stage firms that are seen as capable of generating profits some way out into the future.
“There are many moving parts to a DCF, including assumptions about the long-term operating margin, capital investment requirements, and terminal growth rate of a business, while a further key input is the assumed cost of the company’s funding (be it debt or equity) and the discount rate. The discount rate is used to value the future cash flows in today’s money, by discounting back those expected cash flows at a given rate.
“The greater the uncertainty over the value of the forecasts, the higher the discount rate and the higher interest rates and gilt yields go, then the higher the discount rate will go too.
“And the higher the discount rate, the less the future cash flows will be worth in today’s money. That means a lower valuation for the equity and a lower theoretical share price, although the opposite holds true, too – the lower the discount rate, the higher the equity value and the higher the theoretical share price.”
