UK gilt market vulnerabilities deepen as debt and hedge fund leverage raise systemic risks

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UK gilt market vulnerabilities

Highlights

UK public debt has risen from 28.3% of GDP in 2000 to nearly 100% today, with projections topping 270% by early 2070s under current policies.
The share of gilts held by insurers and pension funds fell from about 66% in 1998-99 to roughly 33% in 2023-24, shifting ownership toward more price-sensitive foreign investors and the Bank of England.
Hedge fund leverage in gilts has reached exposures up to 200 times capital with haircuts as low as 0.50 percentage points, raising systemic risk of abrupt yield spikes and destabilising deleveraging.

Debt pressures and shifting market structure

As reported by Financial Times, concern in the gilt market is centring less on the absolute level of a 10-year yield above 5 per cent and more on how the market's shock absorbers have weakened in recent years. Geopolitical tensions, above-target UK inflation and political uncertainty are adding to pressure, but the broader issue is a steady erosion in the resilience of government bond markets across advanced economies.

In the UK, public debt has climbed from 28.3 per cent of GDP at the start of the century to close to 100 per cent today, after the financial crisis, the Covid pandemic and the energy shock. The Office for Budget Responsibility said in its Fiscal Risks and Sustainability Report last year that, under current policies, healthcare and other age-related spending could push public debt above 270 per cent of GDP by the early 2070s, while also leaving the UK with the third highest borrowing costs among advanced economies after New Zealand and Iceland.

The fiscal strain is compounded by a shortening in the maturity of new debt issuance, increasing rollover risk and making public finances more sensitive to changes in Bank of England interest rates. At the same time, shrinking defined benefit pension schemes are reducing structural demand for gilts, even though higher rates lower the present value of their future liabilities.

The OBR estimates that insurers and pension funds held about two-thirds of gilts in 1998-99, but only about one-third in 2023-24. Overseas investors and the Bank of England, through its asset purchase facility, now account for the largest and second largest shares at 31 per cent and 29 per cent respectively.

Leverage risks and wider financial implications

The changing ownership profile carries wider consequences for market stability because major foreign investors are increasingly price-sensitive hedge funds rather than reserve managers with longer-term objectives. Many of these funds use short-term repo financing to run leveraged relative-value trades, including basis trades that involve buying gilts and selling gilt futures to capture small pricing gaps.

Pablo Hernández de Cos, general manager of the Bank for International Settlements, warns that the growing role of non-bank investors in sovereign debt markets increases the risk of abrupt, non-linear yield jumps, or snapback risk. Larger hedge funds are in some cases borrowing sums equal to or greater than the value of the collateral they post, leaving lenders with little or no haircut protection.

That structure leaves hedge fund strategies highly exposed to shocks in funding, cash or derivatives markets. If margin calls force positions to be unwound, the result can be a destabilising deleveraging spiral that amplifies volatility in core sovereign debt markets.

A new G30 report by Agustín Carstens, Stijn Claessens and Klaas Knot says hedge funds are taking positions with exposure equivalent to as much as 200 times their own capital committed to the trade, with haircuts as low as 0.50 percentage points and sometimes negative. They argue these and related fragilities could push core sovereign bond markets into dysfunction and create a major systemic threat to the global financial system.

Our earlier article on hedge funds’ private-market bets on SpaceX explained how firms such as D1 Capital Partners and Darsana Capital Partners could see outsized gains if the company proceeds with a blockbuster IPO at a much higher valuation. We noted that the potential windfall reflects a broader shift since 2020, as hedge funds have increasingly moved beyond public markets into private assets—blurring the lines with venture capital and private equity and changing how risk and liquidity can show up across the financial system.

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