The cost of UK government bonds continued to fall yesterday as investors prepared for a deluge with new gilts issued to bring the paralysed interbank lending market back to life.

Further details emerged about the possible shape of a government bond-swap programme designed to kickstart interbank lending, which all but stalled following the collapse of the US sub-prime mortgage market last summer.

The Treasury is expected next week to announce a scheme under which the Bank of England will accept asset-backed securities from banks in return for gilts. The banks will then use the gilts as collateral to borrow from each other.

Banks have begged the Government to inject extra liquidity into the credit markets, complaining that the additional £15 billion offered by the Bank has been insufficient. As a result, some British consumers have seen their mortgage rates rocket, while many have been not been able to obtain credit at all.

Speculation on the sum needed to free up the wholesale market has ranged from £15 billion to as much as £100 billion. But with just £3 billion worth of gilts sitting on the Bank's balance sheet, billions of pounds worth of bonds will almost certainly have to be issued to make an impact on lending.

Fund managers said that gilt yields had jumped by 25 basis points since Tuesday, with the yield on a 10-year sterling bond rising from 4.4 per cent to 4.65 per cent. Toby Nangle, a fixed income fund manager at Baring Asset Mangement, said: “The gilt markets have been particularly savage in the last couple of days.”

He attributed the rise in part to a global trend upwards in bond yields but said that the rise was exacerbated in the UK by the prospect of an unknown gilt issuance. In the rest of Europe yields have risen because of continued inflation fears and in the US due to investors' increasing risk appetite. “Normal supply and demand is sending prices down,” Mr Nangle said.

Francis Diamond, a gilts strategist at JPMorgan, said that bond investors were also reacting to the possibility of an easing of credit conditions in the UK. If the Treasury's bond-swap makes it easier for banks to borrow from each other, there is less likelihood of further base rate cuts.

Bond prices rise and yields fall on expectations of a rate cut, so the prospect that the UK base rate will not fall as fast as expected is sending yields up.

Mr Diamond said: “We're seeing an unwinding of rate cut expectations ... there's also some uncertainty about whether the Bank of England will need to issue more gilts to make the plan work.”

But with no official information yet available about how the Treasury's gilts-for-securities swap might work, other analysts said that such fears were overstated. Laurence Mutkin, head of European interest rate strategy at Morgan Stanley, said that the gilts issued were likely to be a special issue and not exchangable for other gilts.

Ownership of the gilts was unlikely to transfer to the banks, so that they would only be able to lend on but not sell them, Mr Mutkin said.

Banks expect to take a severe haircut in the range of 5 per cent to 15 per cent on their asset-backed securities in return for gilts under the swap programme. The Treasury is also likely to issue a substitution clause.

The Bank accepts AAA-rated credit card-backed securities from the European Economic Area (EEA) and AA-rated EEA mortgage-backed securities as collateral against its loans.

If one of these securities is downgraded, banks must replace it with one of an acceptable rating.

Sources said yesterday that they expected the Treasury to set a similar rule for the securities that it accepts in return for gilts. Banks are also expected to have to pay a fee, on top of the haircut, in return for participating in the programme.

Bankers yesterday insisted that the swap did not equate to banks dumping their junk assets on taxpayers, nor exposing Britons to the cost of another bank collapse. Northern Rock has added a £100 million liability to the Government's balance sheet.

Even with a multi-billion injection, credit conditions will remain tough, bankers said. One said: “No one should think that we're going back to the Halcyon days of 12 months ago, when credit was cheap. The mortgage market will still be more difficult to access.”

Banks said that further restraints could be applied to consumer lending, such as the sale of mortgages with rates substantially above their standard variable rate or adding fees for new customers who want to borrow at the standard rate, sources said.

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