Contrasting Market Returns
Equity markets have remained buoyant over recent months as the global economy, despite ongoing geopolitical tensions, continues to expand. Bond markets, however, have not been such a happy place.
The cost of government borrowing has increased. The yield on the UK 10-year government bond is now at its highest level since 2008, while the equivalent rate in Japan has reached levels not seen since 1996.
Higher yields offer more attractive future returns for investors, yet the path to those higher yields has been painful. Bond prices move inversely to yields, meaning rising yields have resulted in capital losses for existing holders.
For investors, the high income payments are offsetting the falling prices, meaning the total returns they receive from government bonds has still been slightly positive over the past year (the IA UK Gilt sector has returned 2.2% for the 12 months to 31 August 2026).
Therefore, this does not represent a crisis for investors, as was the case during the inflation-linked bond sell-off of 2022. However, with governments having to spend increasing amounts on paying these raised yields, this is a growing challenge for public solvency.
Public Spending Needs
For most of the past two decades, successive British governments have attempted to reduce the nation's debt burden, but with limited success. Slow economic growth has coincided with rising demands for public spending, particularly as an ageing population places greater pressure on healthcare, pensions and welfare budgets. Although the austerity years helped slow the pace of debt accumulation, they were insufficient to offset the substantial fiscal support required during both the Global Financial Crisis and the Covid-19 pandemic.
When interest rates were near zero, the cost of servicing this debt remained manageable. Since 2021, however, the combination of higher inflation and higher interest rates has significantly increased borrowing costs. This is not simply a UK problem; governments across much of the developed world are facing similar pressures.
If elevated government borrowing were the only factor driving bond markets, yields would likely be high regardless. However, several additional forces are further contributing to the upward trend.
Funding the AI Boom
One of these comes from the technology sector. Much of the investment underpinning the artificial intelligence boom has, until recently, been funded through corporate profits. As expenditure on data centres and AI infrastructure has accelerated, free cash flow has been running low. As a result, some of the world's biggest technology companies have been issuing a large volume bonds to finance their ambitious spending plans.
While this borrowing sits on corporate rather than government balance sheets, it nevertheless expands the overall supply of bonds. When the supply of bonds increases faster than investor demand, prices tend to fall and yields rise. In other words, the AI investment boom is exerting additional upward pressure on borrowing costs across the wider economy.
Inflationary Factors
Energy markets have added a further complication. Higher oil and gas prices following the conflict between the United States and Iran have raised concerns that inflationary pressures may prove more persistent than previously expected. If inflation remains elevated, central banks will have to raise interest rates further, leaving borrowing costs higher for longer.
Fiscal Choices
Government responses to these challenges vary considerably. The United States benefits from both the dollar and US Treasury bonds being seen as ‘safe-haven’ assets. This emboldens Washington to continue running substantial deficits, despite a relatively strong economy and low unemployment suggesting this is not required and potentially not prudent. Fiscal restraint has yet to materialise, but with bond markets selling off, concerns over government borrowing are becoming more prominent in policy discussions at least, with US Treasury Secretary Scott Bessent among those seeking to reassure markets and ease pressure on yields.
Higher bond yields are therefore a global phenomenon, and UK government borrowing costs have largely risen in line with international peers over recent months. However, domestic fiscal policy still matters. Individual countries can influence how investors perceive their financial stability and long-term sustainability.
Andy Burnham’s Plans
Unlike the United States, the UK benefits from far less tolerance from global investors. Financial credibility must be continually earned. Our new prime minister’s desire to stimulate economic growth across the country is widely known and, if successful, would ultimately help improve the public finances. However, investors will be watching closely for signs that any increase in spending or borrowing is accompanied by a credible long-term plan for debt management.
Bond markets will continue to be influenced by the powerful global forces of rising debt issuance, AI-driven investment spending and inflation concerns linked to energy markets. Yet domestic policy will also play an important role. What is set out in the Autumn Budget may prove significant in determining whether the UK is viewed as merely a participant in these global challenges or as a country adding to them.
For now, equity markets remain focused on economic growth and technological innovation. Bond markets, by contrast, are sending a more cautious message. Investors would be wise to pay attention to both.
Portfolio Positioning
Against this backdrop the Future Money portfolios are being managed with a cautious outlook. While equity markets will always contain risk, in an inflationary environment with broadly reasonable valuations outside of technology markets, these remain the favoured allocations of the Future Money team. Within bond markets, a preference for short-dated debt, which is less sensitive to rising yields, is maintained given consideration for the challenges discussed above.