By Nell Mackenzie and Naomi Rovnick
LONDON (Reuters) -Hedge funds have crowded into debt-fuelled bets on UK government bonds, increasing the potential for instability in the gilts market, a benchmark for borrowing costs in Britain including mortgages, investors and hedge fund sources say.
Bank of England chief Andrew Bailey said in February that non-bank institutions like hedge funds “can propagate liquidity stress in core UK financial markets, notably the gilt market”.
That is partly due to their activity in short-term lending markets, which more than a dozen sources – including portfolio managers, hedge fund executives and a former central banker – described to Reuters.
Hedge funds borrow to fund a variety of trades based on 10-year gilts. Data from electronic trading platform Tradeweb shows they accounted for 60% of UK government bond trading volumes in January and February, up from around 53% at end-2023 and at least a five-year high.
“UK rates markets sometimes trade quite chaotically because large hedge funds push them around and at times there’s not that much real money in them relative to the hedge funds,” said David Aspell, senior portfolio manager at $1.7 billion macro hedge fund Mount Lucas Management, which has flipped in and out of gilt trade positions this year.
With roughly 2.5 trillion pounds ($3.2 trillion) of debt outstanding, the gilts market is dwarfed by the $28 trillion market for U.S. Treasury bonds.
Volatility in bond markets affects government borrowing costs and credit conditions for households and businesses.
KEY TRADES
Hedge fund participation in European bond markets has grown in recent years, and while their positioning has sometimes been a worry, some officials have said they help provide liquidity.
But UK regulators are eyeing how hedge funds use repo markets to position in gilts. Repos – short for repurchase agreements – are a source of funding that can be crucial during times of market stress.
Hedge funds that use repo and are active in gilt markets include Brevan Howard, Capula Investment Management, Millennium Management and Rokos Capital Management, which trade many different financial asset classes under one roof, the sources told Reuters.
Capula, Brevan Howard, Millennium and Rokos, which oversee a combined $150 billion, declined to comment.
Hedge funds currently use repo financing for three distinct bets against gilts, said seven of the sources.
One takes advantage of 10-year gilt prices relative to their futures derivatives. Speculators buy the futures, which currently trade at a premium, and “short” the cash bonds – often called shorting the basis trade. When an investor goes short they borrow securities to sell, hoping to later buy them back more cheaply.
A second bet, that UK inflation will remain high, involves shorting 10-year gilts and buying two-year bonds.
A third trade has seen trend funds put on bets against 10-year gilts for seven out of the past nine weeks, JPMorgan data from March 17 shows.
Such trades are only a slice of hedge funds’ individual portfolios but their combined impact has raised concerns.
The sources all said that, to fund their gilt positions, hedge funds are using up a disproportionate share of borrowing available in the UK repo market, a key part of the financial system’s plumbing.
Jillien Flores, chief advocacy officer at the Managed Funds Association, said diversity of participants helped improve liquidity and market efficiency, adding: “Alternative asset managers help reduce the cost of UK government borrowing through their participation in the gilt market.”
Exclusive data from S&P Global Markets for Reuters shows average use of repo on 10-year gilts over a year-high in February.
Repo markets allow the holder of a bond to lend it out temporarily in exchange for cash, a quick and cheap way of borrowing. Typically banks lend bonds to hedge funds, pension funds, large corporations and each other.
The BoE warned in November that hedge funds’ rising share of repo borrowing could deprive other institutions of funding, especially if banks lend less during spells of market stress.
Among those vulnerable to gilt selloffs are pension schemes, which borrow in repo markets to finance hedging positions. These derivatives contracts require more cash to secure them when gilt yields rise, which if the repo market is tight can trigger fire sales of liquid assets – including gilts, accelerating the selloff.
“This is where a market selloff can start,” said Andy Hill, managing director at the International Capital Markets Association.
“You need the repo market to work. There is the risk that, in highly volatile times, as balance sheets become more expensive, banks might step away from intermediating.”
When gilts sold off in January, pension funds posted 3 billion pounds ($3.9 billion) in extra collateral, said a BoE blog on March 6.
To ease that risk, the BoE has developed a new liquidity facility for gilt holders like insurance companies and certain pension schemes, but to apply they must hold at least 2 billion pounds worth of UK bonds.
The March 26 release of official growth and borrowing forecasts is seen as the next big test of UK market sentiment.
James Athey, fixed income manager at Marlborough, warned of disruption if hedge funds rush to the exits.
“When you have market shocks and changes, rapid unwinds of positions because of these changes can escalate and cause stability issues,” he said.
($1 = 0.7704 pounds)
(Additional reporting by Yoruk Bahceli; Editing by Dhara Ranasinghe, Elisa Martinuzzi and Catherine Evans)
