Growing political pressure on British Prime Minister Keir Starmer is pushing up UK government borrowing costs, but political uncertainty is not the only factor driving British bond yields to the highest levels among major advanced economies.

Yields on 10-year UK government bonds which determine the governments future borrowing costs rose on Tuesday to 5.13%, the highest level since 2008.

Gordon Shannon, partner at investment firm TwentyFour, which manages 23.5 billion ($32 billion) in fixed income assets, said: There is a significant amount of fear reflected in the pricing of UK bonds.

He added that most potential candidates to succeed Starmer who came to power in July 2024 with a large parliamentary majority may seek to increase government borrowing, with the possible exception of Health Secretary Wes Streeting.

Shannon noted that Andy Burnham, the mayor of Greater Manchester, who would first need to return to parliament in order to succeed Starmer, could borrow an additional 50 billion over five years, almost 12% above current borrowing plans, if defense spending is excluded from current fiscal rules as he previously proposed.

Memories of the Liz Truss crisis remain present

The experience of former Prime Minister Liz Truss still casts a shadow over the appeal of UK bonds to international investors.

Her tax-cutting program triggered a collapse in long-term bond prices, forcing the Bank of England to intervene to halt a sharp selloff by pension funds amid fears of so-called bond vigilantes.

Kevin Thozet, investment committee member at French asset manager Carmignac, said investors imposed what he described as a moron premium on Britain after the mini-budget crisis launched by Truss, adding: We may be heading back toward a similar environment.

However, Shannon ruled out a repeat of the same sharp selloff, explaining that British politicians who want to increase borrowing now understand the need to prepare markets in advance and retreat if negative reactions emerge.

UK 10-year bond yields stand at around 5.12%, compared with 4.45% in the United States where economic growth is stronger and 3.10% in Germany, which is viewed as more fiscally disciplined.

Since the start of the year, UK yields have risen by 0.64 percentage points, more than double the increase recorded in comparable US and German bond yields.

Although higher yields affect only the cost of new debt, meaning the impact on the government budget is not immediate, Britains fiscal watchdog estimates that every one-percentage-point increase in yields would cost the government an additional 15 billion annually in debt interest by 2030.

In contrast, the government has only 24 billion of fiscal headroom to meet its target of balancing the current budget by 2029-2030.

Britain is more exposed to inflation

Alexandra Ivanova, fund manager at Invesco, believes politics is not the only factor behind the rise in UK borrowing costs.

She said: We need to remind investors of the basics of finance. You have to think about what you are being paid for in the yield: liquidity risk premium, political risk premium, term premium, inflation risk premium... and in the case of UK bonds, every one of these components is higher than almost anywhere else.

She added that UK bonds do not look like an attractive bargain despite their high yields.

Inflation risk is the clearest factor, as the US-Israeli war with Iran has pushed oil and natural gas prices up by around 50% since the end of February.

Britain relies on natural gas imports, while the Bank of England expects inflation to exceed 6% early next year if energy prices remain high for a long period. Before the outbreak of the war, the central bank had expected inflation to return to its 2% target.

While inflation in the eurozone had returned to target levels before the war, it remained more persistent in Britain due to higher services prices, regulated utilities, and wage growth since the coronavirus pandemic.

Financial markets are currently pricing in the possibility of the Bank of Englands key interest rate rising to 4.5% by February 2027, compared with the current level of 3.75%, while pre-war expectations had pointed to one or two rate cuts.

Higher volatility in UK bonds

Another less obvious reason for higher UK yields is that British government bonds are more volatile than their US and German counterparts.

For most of the past 20 years, British pension funds and insurance companies bought long-term bonds to cover their future liabilities, but the shift by companies away from defined-benefit pension schemes ended this trend.

Nicola Trindade, senior portfolio manager at BNP Paribas Asset Management, said current buyers of UK bonds are often foreign hedge funds that are more price-sensitive and operate with shorter investment horizons, increasing market volatility and prompting investors to demand higher yields.

Some investors also blame the Bank of Englands bond-selling program worth 70 billion annually as one of the factors pushing yields higher.

Although Shannon believes the political risk premium may decline over the medium term, he pointed to the difficulty of assessing the other factors.

He concluded: You need to attract a diverse range of foreign investors, and constantly changing prime ministers is not what people want to see.

The British pound

The British pound fell against the dollar and the euro on Tuesday as markets closely monitored political developments amid growing concerns that British Prime Minister Keir Starmer may step down.

Starmer was holding consultations with colleagues over whether he could remain in office ahead of a decisive cabinet meeting, after the resignation of ministerial aides and a public call by around 80 lawmakers for him to leave.

The British pound fell 0.45% to $1.3550, after rising more than 0.5% last Friday when Starmer pledged to remain in power following the heavy losses suffered by the ruling Labour Party in local elections. Sterling had recorded $1.3658 last week, its highest level since February 16.

The British pound also declined 0.17% to 86.72 pence against the euro, its lowest level since April 28.

Investors fear that if Starmer is forced to leave office, he may be succeeded by a more left-leaning leader within the Labour Party, which could lead to higher government borrowing, putting additional pressure on Britains already fragile fiscal position and damaging bond and currency markets.