Hedge funds a large, risky player in bond market

Hedge funds now account for about 40% of government bond auction allocations, up from effectively zero just 15 years ago, the paper noted. As a result, “hedge funds now represent a significant investor class — the largest class after dealers,” it said.

The rise in hedge fund participation has been facilitated by increased government bond issuance, which makes it easier for these funds to take the kind of large positions they need to effectively generate returns.

“Because the [government] bond market is relatively liquid and efficient, smaller mispricing opportunities can mean that hedge funds need to take larger positions to achieve their desired return,” the paper said. So, rising bond issuance has facilitated hedge funds’ participation, and the liquidity of that market means transaction costs are relatively low too.

Additionally, other types of investors aren’t as driven by the increase in issuance, it suggested, “mainly because they have less flexibility and greater difficulty taking on leverage.”

However, this increased hedge fund participation also represents a risk, the paper said, as these kinds of investors may also be more likely to flee the market.

“This greater flight risk is why the increased concentration of hedge funds in sovereign debt markets globally has been seen as contributing to a riskier investor base that compounds the risks from higher general government debt,” it said.

Hedge funds are more likely to exit the market for several reasons, the paper noted — they have a higher failure rate than other kinds of investors, they face refinancing risks due to leverage or margin calls, and they are mostly foreign investors. “Without organic commitment to the Canadian market, they could be more likely to pull back during a Canada-specific stress event,” the report said.

While the government bond market has generally benefited from increased hedge fund participation, this phenomenon also brings “rising risks of potentially significant investor outflow, given hedge funds’ business models, lack of natural anchor to the [government] bond market and dependence on the repo market to obtain leverage,” the paper concluded.