British government bonds, nicknamed gilts after the gold leaf that used to adorn the paper certificates, have surged in price alongside U.S. and German government debt as investors have scurried away from riskier stocks and the questionable debt of crisis-hit, mainly southern, euro zone countries.

They have been helped along also by huge stimulus buying from the Bank of England, which it suggested in minutes released on Wednesday it is willing to start up again if the economy worsens.

But gilts may not be as safe a haven as some investors are counting on, with Britain suffering from hefty public borrowing, relatively high inflation and significant exposure to any worsening the euro zone economy itself.

"The UK has essentially used up all of its wiggle room," said Sam Hill, a fixed income strategist at RBC who previously worked for fund managers Threadneedle Investments. "The UK might be in some ways separate, but would equally still be dragged down ... if there was a more severe outcome in Europe."

Investors' desire to avoid risky assets -- along with pump-priming buying by the Bank of England -- has sharply reduced the annual interest rate, or yield, that Britain's government has to pay on new debt.

For benchmark 10-year gilts, the yield sank to 1.809 percent on Friday from over 4 percent in more normal times a couple of years ago. It was lowest yield since similar gilts were first issued after World War Two.

Over the same two-year period, a markedly different view of Spanish debt has taken yields from 4 percent to over 6 percent. Demand for German debt, meanwhile, has been even greater than for British -- two-year government bonds sold on Wednesday will pay nothing.

The falling return on gilts, however, does not reflect any reduction in their outright risk. The cost of insuring gilts against default has risen almost 30 percent over the past year, compared with an unchanged cost for U.S. debt.

Despite this, 10-year gilts offer a yield that is only 0.1 percentage points higher than U.S. Treasuries and 0.4 percentage points over German Bunds.

"I wouldn't say gilts are a particularly good investment relative to Treasuries," said Ian Fishwick, a fixed-income fund manager at Fidelity Worldwide Investment, which holds about 2.5 billion pounds of gilts.

"The UK does have a problem with the scale of public debt and ... the dollar's reserve currency status is a lot more secure than sterling's," he added.

PROBLEMS LURK

Britain's annual government borrowing amounts to more than 8 percent of gross domestic product. This is roughly triple Germany's rate of borrowing, and only slightly below that in the United States - which has the advantage of stronger long-term growth with which to service the debt.

Moreover, Britain's economy and banking system is much more vulnerable to a euro zone downturn than the United States is, with around half of Britain's trade going to the rest of Europe.

"The main scenario where you would say it is over for gilts is a loss of credibility in the government's fiscal credibility, and that's a scenario that you could imagine if there was a nasty euro break up," said RBC's Hill.

Despite these reservations, fund managers such as Fishwick still believe that on balance it is safer for UK investors to keep at least some assets in gilts than the alternatives.

Others share this view too, and over the past 12 months, 10-year gilt prices have risen by around 15 percent, teaching a painful lesson to those who felt they were already overpriced.

However, many analysts do not expect these gains to be sustained and think a gradual fall in gilt prices as the economy recovers is the most likely medium-term scenario.

From an investor's point of view, taking a moderate loss on a gilt portfolio in the event of an economic upturn may be an acceptable price for the capital protection that gilts are meant to provide in case the euro zone crisis deepens.

ONE OFFS

There is a risk that gilt prices are more inflated than other safe-haven assets due to UK-specific one-off sources of demand, said David Miller, a partner at Cheviot Asset Management, which controls around 3.5 billion pounds of funds.

One source of demand has been UK banks seeking to meet regulatory requirements to boost capital - a source which may soon dry up.

The Bank of England's 125 billion pound purchase of gilts between October and the start of May under its quantitative easing program is another. It now owns more than a quarter of the market.

These gilts do not look likely to be sold any time soon, but it is hard for investors to know how much will be bought in future and/or when stimulus tasks will be turned off, making gilts riskier than say U.S. Treasuries.

And taking into account the higher inflation in Britain than in Germany or the United States some investors such as French fund Carmignac Gestion see no attraction in gilts at all.

"The UK is running a first-class act. They are stealing 2 percent a year from investors," said the fund's chairman Edouard Carmignac, who manages 50 billion euros - none of it in gilts.

(Reporting by David Milliken. Editing by Jeremy Gaunt.)

• A Permanent Economic Emergency