The involvement of hedge funds in bond markets has its positives, but the Bank of Canada isn’t alone in its concerns, writes Mark Rendell.Sean Kilpatrick/The Canadian Press
A small number of hedge funds are playing an outsized role in the Government of Canada bond market, improving market efficiency but creating potential financial stability risks, according to new research by the Bank of Canada.
A report published on Tuesday highlights the growing footprint of hedge funds in Canada’s bedrock bond market, as well as the highly concentrated nature of their involvement.
Between 40 per cent and 50 per cent of new bonds issued by the federal government are now routinely purchased by hedge funds, who use a range of complex trading strategies to profit off market movements and mispricing.
In addition, a significant portion of GoC bond trading is dominated by a handful of hedge funds, the central bank researchers said without naming the funds. For some prominent hedge fund strategies – involving billions of dollars worth of trades – almost 70 per cent of trading activity is conducted by only five funds.
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The involvement of hedge funds in bond markets has its positives. The extra demand for debt helps Ottawa borrow large amounts of money without interest rates spiking. And hedge fund trading activity adds liquidity to the market, making it easier for other investors to transact.
However, hedge funds are not like other types of bond owners. The typically foreign funds borrow large amounts of money in short-term repo markets to finance their positions, and are more prone to sell during market disruptions, with potential cascading effects.
“The high concentrations suggest that if just one or two firms were to rapidly unwind their positions it could lead to a substantial and sudden spike in bond sales that could be a challenge for the market to absorb,” wrote Andreas Uthemann and Adrian Walton, the principal researcher and assistant director of the Bank of Canada’s financial markets department.
“Our results also suggest that market conditions that generate stress could affect many funds simultaneously through their common exposure to a given strategy,” they added.
The bank has highlighted the potential risk of growing hedge fund participation in Canadian bond markets for several years, both in its annual Financial Stability Reports and staff research papers. What’s new in this week’s report is an effort to quantify different hedge fund trading strategies – which often involve buying and selling pairs of different bonds at the same time – and to highlight how concentrated the market is.
“Identifying and quantifying different strategies is important because each strategy involves distinct risks that could come from, for example, liquidity constraints, a drop in bond issuers’ credit ratings or changes in interest rates,” the authors wrote.
The growth of hedge funds in the GoC bond market has been extraordinary. Fifteen years ago, they accounted for less than 5 per cent of most bond auction purchases. Today, they account for nearly half of the orders in many auctions, and have become an increasingly important source of demand as federal deficits have widened and debt issuance has soared since the start of the COVID-19 pandemic.
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“The fact that there’s a large amount of capital that can be put to work does help keep Government of Canada borrowing costs down, all else equal,” said Taylor Schleich, a rate strategist with National Bank. “But as the Bank of Canada outlines, you become more exposed to risk-off sentiment and to key risk events, whether it’s sourced in Canada or from a risk that comes from abroad.”
There have been several prominent examples in recent years of bond markets being roiled by a sudden shift in investor expectations that forces hedge funds to rapidly unwind their trades. This happened in Britain in 2022 after then-prime minister Liz Truss’s notorious mini-budget, and again in recent weeks after Japan’s Prime Minister Sanae Takaichi similarly suggested unfunded tax cuts.
“Right now Canada is in a pretty strong fiscal position, but deviating from that significantly or putting forth an unsustainable fiscal plan is something that bond markets will punish you for. And probably hedge funds would be at the forefront of that given just how in-and-out of markets they tend to be,” Mr. Schleich said.
The Bank of Canada isn’t alone in its concerns. In its most recent financial stability report, the Bank of England warned that “concentration in UK core markets is pronounced” with 90 per cent of net repo borrowing being done by “a small number of hedge funds.”
Jim Byrd, global head of macro trading at Royal Bank of Canada, said the growing presence of hedge funds in the Canadian bond market isn’t necessarily a long-term concern. They’re buying and selling bonds at the same time, which means “their net bond market support is materially less than the auction participation levels might indicate,” Mr. Byrd said in an e-mail.
“The one area that could cause concern is that the funds are also largely financed by Canadian dealers via fixed income repo,” he added. “If there were a constraint on fixed income repo capacity at the banks, the funds would have to unwind their positions which could create some short term dislocation.”