The Bank of England has issued a stark warning over the growing threat posed by international hedge funds to the stability of the UK's government bond market. In its latest Financial Stability Report, the central bank highlighted that these funds are taking on record levels of debt to bet on small price movements in UK government bonds, known as gilts, creating a dangerous vulnerability for the economy.
Record Leverage and Systemic Risks
According to the report, published on Wednesday 3 December 2025, hedge funds used their gilt holdings to borrow an extra £100 billion in cash during November alone. This marks the highest level of leverage since the Bank began monitoring this activity in 2017. Officials cautioned that this behaviour "increases the risk of sharp moves" in the gilt market.
The situation has arisen because pension funds and insurers, traditionally steady holders of government debt, have diversified their investments following regulatory changes. This has left the UK government increasingly reliant on a small group of hedge funds, which operate on much shorter timeframes and use borrowed money to amplify their returns.
Exploring Limits to Avert a Crisis
Andrew Bailey, the Governor of the Bank of England, confirmed that officials are actively exploring plans to limit the size of hedge fund bets on gilts. The concern is that during a financial downturn, these highly leveraged, mostly foreign funds could be forced to sell their holdings rapidly to cover debts.
"Forced or widespread deleveraging would have the result of amplifying initial moves and potentially triggering a feedback loop of further forced selling," warned the Bank's Financial Regulation Committee, which Bailey chairs. Such a sell-off would cause government borrowing costs to soar, threatening public finances and creating a major systemic risk.
Broader Market Vulnerabilities for 2026
The stability report also flagged several other escalating risks that could culminate in a market meltdown next year. Key concerns include:
- AI Infrastructure Debt: A rapid rise in corporate bond and private credit issuance to fund artificial intelligence projects, deepening links between risky "shadow banking" and the tech sector.
- Stretched Valuations: Equity markets, particularly in the US, are at their most overvalued since the dot-com bubble, driven by AI speculation. UK stocks are also at post-financial crisis highs.
- Corporate Debt Risks: Riskier lending practices in corporate debt markets linked to AI expansion.
The Bank's Financial Policy Committee concluded that "risks to financial stability have increased during 2025" and that the chance of a "sharp correction" in equity markets is more likely in 2026.
