THE fluctuating VOLATILITY OF UK BOND MARKETS

This article looks at the dynamic nature of bond market volatility.  What it means for portfolio construction.  And how short-run measures help spot the canary in the coalmine.

Volatility is dynamic.  Managers should be too.

The good old days

Before the Global Financial Crisis and the distorting era of Quantitative Easing and near-zero interest rate policy it ushered in, normal markets, could safely assume that equities offered higher risk-return, bonds offered lower risk-return, and a multi-asset 60/40 portfolio provided a diversified balance of the two.
But the return of inflation to developed markets after being dormant since the 1970s offered a stark reminder of how that regime falls part when some key assumptions change.
In a higher inflation regime, nominal bonds no longer provide a store of value, and the rising interest rates to fight inflation have an adverse impact on the price of longer duration bonds.  The combination of interest rate and inflation volatility means bonds themselves become more volatile too.
Whereas risk profiling tools and investment committees rely on long-run (eg 10 year) capital market assumptions, the performance that actually impacts investors year to year are the short-run dynamics.
The key consideration is that asset class volatility is not stable as capital market assumptions seem to imply.  It is in fact highly dynamic over shorter time-frames.

The 1 year volatility picture

The chart below shows the 1 year volatility of World Equities (in GBP), Gilts and a 60/40 equity/bond index (represented by the UK Multi-Asset Index 60% Equity GBP Index).

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At the end of 2006 (before the Global Financial Crisis), the volatility characteristics were similar to long-run expectations – and investment textbooks.
At the end of 2022, following the unleashing of inflation and the Truss/Kwarteng Gilts crisis, the volatility of gilts was closer to equities.  For investment managers relying on classical portfolio theory got wrongfooted – to the detriment of their clients.
At the end of 2025, bond volatility had settled down again – but that’s before US/Iran war commenced.

What that means for portfolio construction

If bonds are contributing risk, not stability, then managers need to think of alternative sources of stability and diversification.  We believe an all-weather strategy makes sense – a risk constrained absolute return fund that has similar volatility characteristics to traditional bonds, but with a differentiated return pattern.  The true measure of diversification is to what extent that all-weather alternative to bonds has a low or no correlation with equities or bonds.  The lower the better for true diversification.

The immediate volatility picture

By monitoring immediate (30 day) volatility, we can monitor changes in bond market behaviour more closely, for any early-warning signals, that gilts are getting unsettled.  The volatility canary in the bond coalmine.
The chart below shows the immediate (30 day) volatility as at selective dates.

In the calm before the Global Financial Crisis, Gilts volatility was 3.7% as at Dec-05.  This increased following the financial crisis, through Brexit and into Covid.  Gilts volatility spiked during the infamous Truss/Kwarteng budget which was exacerbated by automated selling by Liability-Driven Investment strategies.  By December 2024, following Labour’s strong majority with a promise to end the chaos and put Government finances back in order, Gilts volatility declined to 4.7% as at Dec-24.  Tracking the progression each quarter end since then saw early 2025 debt indigestion worries managed and stability returning by end December 2025 with volatility dropping to 4.2%.

Volatility starting to spike again

With the US/Iran war, inflation is unleashed once again, compounded by political uncertainty and the risk of a leftward lurch to less fiscally responsible policy making.  Gilts volatility is therefore on the rise and needs to be monitored carefully.

How should asset allocators adapt

Given bond volatility is far more dynamic than the classical textbooks would imply, we believe asset allocators need to be agile too.  Active management of 1) the size of any allocation to bonds, 2) the composition of a bond portfolio and 3) the overall duration of that portfolio are key levers for managers to consider to navigate the changing volatility of the bond market.