Oct. 8 (Bloomberg) -- U.K. two-year notes rose after the Bank of England joined central banks around the world in cutting interest rates to ward off a collapse of the financial system.

Britain's central bank reduced its key rate half a percentage point to 4.5 percent a day before its scheduled decision. Policy makers in the U.S., euro region, Sweden, Switzerland, Canada and China also reduced rates. The U.K. government said earlier it will invest 50 billion pounds ($87 billion) in the nation's banks to help ease the lending freeze.

``The rate cut in the context of the plans to bail out the financial sector tells you that U.K. policy is coming to terms with the problem,'' said Russell Jones, head of global fixed- income and currency research in London at RBC Capital Markets. ``The general situation for global bond markets is good and that extends to the gilt market. And you could argue there's still a lot of potential for rate cuts in the U.K.''

The yield on the two-year gilt dropped 9 basis points to 3.49 percent by 5:14 p.m. in London. The 4.75 percent security due June 2010 climbed 0.15, or 1.5 pounds per 1,000-pound ($1,741) face amount, to 102.01. The 10-year gilt yield rose 5 basis points to 4.29 percent. Bond yields move inversely to prices.

That pushed the difference in yield, or spread, between two- and 10-year gilts to 79 basis points, the widest since July 2003, as investors favored shorter-dated maturities.

Bonds were also supported as the National Institute for Economic and Social Research said Britain entered a recession in the third quarter. Gross domestic product shrank 0.2 percent in the three months through September, the first contraction for a calendar quarter since 1992, the Niesr said. Consumer confidence fell to its lowest level since at least 2004, a separate report by Nationwide Building Society showed.

`Human Nature'

``We have clients who said they don't want anything'' but short-dated gilts, said John Anderson, head of fixed-interest investments in London at Rensburg Fund Management, which has about $2.6 billion in assets. ``It's an ultimate form of risk aversion. We are not dealing with value here. We are dealing with human nature.''

The pound weakened, slipping to $1.7317, from $1.7455 yesterday, and 78.98 pence per euro, from 77.87 pence. The FTSE 100 index of stocks dropped 5.2 percent, bringing its decline this week to 12 percent.

As part of the U.K. rescue package, the government will buy preference shares in banks, and the Bank of England will make at least 200 billion pounds available for financial institutions to borrow under the so-called special liquidity plan, the Treasury said in a statement today.

No Turnaround

``The U.K. is looked upon to lead the way out of the crisis,'' said Neil Jones, head of European hedge-fund sales in London at Mizuho Capital Markets. ``The total size of the package is far larger than initially expected. But I don't see it as a turnaround for sterling.''

The government said it will also provide a guarantee of about 250 billion pounds to help refinance debt. The steps provide ``the necessary building blocks to allow banks to return to their basic function of providing cash and investment for families and businesses,'' Chancellor of the Exchequer Alistair Darling said in a separate statement.

Barclays Plc and Royal Bank of Scotland Group Plc, the U.K.'s second- and third-biggest banks, said they plan to participate in the government rescue.

To contact the reporter on this story: Agnes Lovasz in London at alovasz@bloomberg.net

Last Updated: October 8, 2008 12:18 EDT