Five-year gilt yield hits 2008 high as UK banks face tax hike

A record price for five-year money

On the eve of John Healey's first budget as chancellor, Britain paid more to borrow for five years than at any point since the financial crisis. On Tuesday the Debt Management Office sold £4.5bn of the 4.625% March 2032 gilt at an average yield of 5.036%, the highest for five-year issuance since 2008.5 Investors bid for 3.51 times the amount on offer. The DMO described that as typical of the strong demand for British government debt this year.5

Every outlet covering the auction agrees on those numbers. They differ in tone. Reuters, whose report was widely syndicated, treated the sale as a sign of bond-market pressure on the chancellor.3 City AM said the DMO had been "forced" to pay up and noted that the UK now spends more than £115bn a year on debt interest. That is more than the education budget for England and about twice what the country spends on defence.9 This is Money went furthest, quoting economists who warned of a repeat of the 2022 mini-budget if Healey unsettles investors with more borrowing.8 The Guardian's markets coverage was calmer. It pointed out that long-dated yields had already come down from their autumn peaks, and that the bond market was quiet going into the budget.1

The calmer view is the better one. A cover ratio of 3.5 times is not a failing auction. What it shows is a market that will lend to Britain at a high price, and the high price is the story.

Why yields are where they are

The reporting largely agrees on the cause: an energy shock, not anything specific to Britain. Bond yields have jumped across advanced economies since the US-Iran war began, because investors expect higher inflation and more government borrowing.5 Earlier in October, 20- and 30-year gilt yields hit their highest levels since 1998, and 5- and 10-year yields reached highs last seen in 2008.5 One market explainer puts the 10-year peak at about 5.53% on 8 October, the highest since 2007. It also says the 30-year briefly went above 6%.19 The 10-year was around 4.40% before the March spring forecast and about 5.43% by 21 October.15

The fiscal cost is large. Reuters notes that in March, before most of the rise, the Office for Budget Responsibility already expected debt interest to reach 3.8% of national income by the end of the decade. That is close to double the 2010s level.5 Lloyds economists estimate that higher gilt yields and expected short-term rates since March add roughly £14bn to borrowing in 2029-30.14 Analysts have warned that this could halve the £24bn buffer Rachel Reeves had built up against the fiscal rules.13

The DMO is already adjusting. Gilt dealers polled by Reuters expect only a small rise in issuance this year. They do expect a £27bn jump in the 2027/28 gross financing requirement, to £334bn. They also expect long-dated issuance to fall to its lowest since 1990/91 as the DMO shifts to cheaper short-dated debt.2 Bank Rate was 3.75% in late October, and a Reuters poll points to a rise in November.15

The banking paradox: higher yields, higher earnings

The yield rise that is squeezing the Treasury is helping the banks, and that is why lenders have become the obvious target for new revenue.

The main channel is the structural hedge. Banks invest stable deposits in fixed-rate assets and roll them over as they mature, so higher yields slowly lift their income. HSBC's third-quarter results, released on budget eve, showed this clearly. Pre-tax profit rose 32% to $9.6bn, and the bank announced $2.7bn of dividends and buybacks.1 Net interest income rose 6% to $9.3bn, which HSBC put down to deposit growth and better returns from reinvesting its structural hedge.17 Much of the 32% headline increase came from not repeating a $1.4bn legal provision taken a year earlier. Profit was also slightly below the consensus Reuters cited.17 The shares fell more than 5%, according to the Guardian, and over 6% in another account.16 The fall left HSBC behind Shell as London's most valuable listed company.1

Barclays' quarter showed the same pattern. Pre-tax profit rose 12% to £2.3bn, group net interest income rose 4% to £3.9bn on the back of structural hedge income, and the bank announced a £500m buyback. Its UK corporate bank increased net interest income by 14%.26 Opinion on the quarter was split. Sharecast called it a profit miss against expectations of £2.4bn.27 Investing.com noted a small earnings-per-share beat alongside a revenue shortfall.26 The numbers for the equities trading business also differ: one account gives equities income of £1bn and another £1.5bn, both up 47%.27 The broad conclusion holds either way. Barclays' Wall Street-style trading desks made up for weaker fixed-income activity, and its domestic lending business did well from higher rates.27

The domestic lenders report after the budget. Lloyds publishes on Thursday and NatWest on Friday.28 NatWest is expected to post a flat operating pre-tax profit of about £2.2bn.22 Analysts forecast a near-doubling of Lloyds' quarterly profit to £2.3bn, though mostly because last year's figure included a £1.95bn provision for motor-finance compensation.21 Breakingviews has calculated that analysts' net interest income forecasts for Lloyds and NatWest together have risen by about £500m since before the war.20

Why bank shares have not rallied

If rates are lifting income, why are bank shares falling? Citi gives the clearest answer. In its analysis, the gilt sell-off helps structural hedge income but also raises banks' cost of equity, which has pushed valuations down and helps explain why UK banks trade at a discount to peers.12 Higher rates also have direct costs. Jefferies estimates that a half-point rise in the yield curve could eventually cut loan balances by 2-3 percentage points compared with steady rates.20 RBC downgraded Lloyds in mid-October because deposit competition is squeezing margins.23

Then there is tax. Shares in Lloyds and NatWest, which earn most of their money in Britain, fell on 16 October after reports that Healey would raise the bank surcharge. HSBC and Standard Chartered, which earn mostly abroad, rose that day.12 That split is what you would expect if markets are pricing a UK-only tax rather than a problem for the whole sector.

The surcharge fight

The Guardian reported that Healey intends to tap the financial sector to keep deficit reduction on track. The most likely step is reversing Jeremy Hunt's 2023 cut, which would take the surcharge from 3% back to 8% on top of corporation tax.13 Estimates of the yield vary widely. KBW put it at about £2bn a year and calculated it could reduce lenders' earnings by 6%.12 The TUC estimates £2.25bn a year.13 The New Economics Foundation says £5.8bn to £7.6bn by the end of the parliament, depending on assumptions.17 Campaigners want much more. The TUC argues that a 16% surcharge would raise £24bn over four years and a 35% rate, matching the energy windfall levy, about £60bn.17

The banks appear to have accepted a rise and are now arguing about its size. Barclays chief executive C.S. Venkatakrishnan called a tax increase "bearable", pointing to how much of the bank's profit comes from outside Britain.21 Lloyds boss Charlie Nunn has reportedly told investors the bank could absorb a surcharge of 4% or 5% without changing its guidance.28 Industry sources told the Guardian that lenders were resigned to a return to 8%, though not to anything higher.13 Lobby groups UK Finance and TheCityUK have warned that higher taxes could push staff and business out of Britain. JPMorgan's Jamie Dimon said in May that he could drop plans for a £3bn London headquarters if the government turned hostile to banks.13 Breakingviews argues that a modest levy paired with regulatory relief could soften the blow.20 Barclays has listed Basel 3.1 and Pillar 2A capital changes among its regulatory uncertainties.26

The reading

The five-year auction is less a warning of crisis than a statement of cost. Strong demand shows Britain can still borrow easily, but at a price that limits what the chancellor can do. Banks are clear winners from that price through their hedges, and Healey is short of money. Taxing them is the easiest choice politically, which is why a surcharge rise looks close to certain. The real question is the rate. A return to 8% would roughly restore the pre-2023 position, a change investors in domestic lenders seem to have largely priced in. A higher rate would be a new policy, and given the cost-of-equity effect Citi describes, it could weigh on bank valuations for longer than the revenue gain would justify.

For the gilt market, the measure that matters most is the OBR's headroom figure, not any single tax. Fund managers have suggested that a buffer below £10bn would disappoint gilt investors.19 Analysts quoted on budget eve said markets want a dull budget with credible fiscal control.1 Higher taxes on banks can help deliver that, as long as the overall arithmetic adds up.