Trevor Greetham: Higher yields put gilts back in the frame

Much has been written about the problems facing a new British government ‘in hock’ to the bond markets, but we should remember that the case for gilts in a multi-asset portfolio has strengthened considerably in recent years, with higher yields now the norm. It’s not so much about politics as valuation.

Ten-year UK government bond yields dropped to a pandemic low of 0.1% on August 2020. At the time, we described gilts as “return-free risk”, rather than the traditional “risk-free return” you’re meant to get from sovereign bonds.

A buyer would have needed consumer prices to deflate over a decade to make a positive return in real terms. That was never going to happen.

A more inflationary post-Covid recovery was in prospect, even before Russia invaded Ukraine and oil prices spiked. Yields hit 4.5% at the time of the Liz Truss mini budget of September 2022. Long-dated index-linked gilts lost 70% of their money in two years. Even more in real terms.

The good news for investors today is the starting yield you’re buying at is reassuringly high, at around 4.7%. In the oil crisis of 2026, yields never got higher than 5.2%. Government bonds are once again providing ballast in a portfolio as well as a hedge against deflationary shocks.

From global cuts to global hikes

At the start of 2026, the narrative around bond markets was straightforward. Growth was slowing, inflation pressures were easing and central banks were shifting towards a more accommodative stance.

Higher energy prices started to feed through into inflation and policy expectations adjusted accordingly

Expectations moved from coordinated easing to coordinated tightening after the US and Israel attacked Iran. The change in yields was driven by global politics, not domestic politics.

All government bond markets reacted to developments in the Middle East. Higher energy prices started to feed through into inflation and policy expectations adjusted accordingly.

Coming into the year, the Federal Reserve, Bank of England and ECB had all been expected to cuts rates by year end. Now all are expected to hike, with US expectations moving most sharply as new Fed chair Kevin Warsh vowed to “restore price stability” (Chart 1).

Supply damage longer lasting?

Over most of June optimism grew that the US and Iran were moving towards a peace deal that will reopen the Strait of Hormuz, but it always looked like fragile peace. Progress of sorts had seen equity markets advance and commodity prices reverse some of their gains, but bond markets had been slower to re-price the outlook.

This divergence may reflect scepticism about how quickly oil flows can normalise. Even as the fragile peace deal held, the number of tankers passing through the Strait remained very low while oil supplies depleted (Chart 2).

Trevor Greetham: Markets are strong despite Middle East risk

As the conflict has intensified over recent weeks, flows through the Strait have once again come to a standstill.

Markets are also factoring in lasting supply problems with crude oil contracts for December delivery trading 35% above levels seen at the start of the year. Elevated energy prices place a floor under inflation and, by extension, bond yields, challenging the notion of a smooth return to a rate cutting cycle.

UK politics playing second fiddle

With such dramatic swings in oil prices impacting government bonds in every region of the world, it would be wrong to build a gilt market narrative solely around domestic politics.

But that’s not to say politics don’t matter at all. The markets seem to like the fact Andy Burnham will replace Keir Starmer as prime minister next week without the need to make additional spending commitments in a protracted Labour leadership contest.

If Burnham can add some urgency to EU-UK summits to reduce trading barriers, fiscal sustainability could actually improve

Fiscal credibility will be key, and investors will also take some cheer from his commitment to “current fiscal rules”.

Burnham is making a strong ‘levelling up’ pitch, presumably to take the wind out of his populist opposition by delivering on some of the promises of Brexit. If, at the same time, he can add some urgency to EU-UK summits to reduce trading barriers, fiscal sustainability could actually improve.

Keir Starmer is the sixth prime minister to lose their job since the EU Referendum ten years ago. Andy Burnham’s challenge is to buck this trend. Time will tell. As investors in gilts – and in stark contrast to 2020 – we are being paid while we’re waiting.

Trevor Greetham is head of multi asset at Royal London Asset Management