Bank of England Deputy Governor Warns Hedge Funds Raise Bond Risks

Bank of England Deputy Governor for Financial Stability Sarah Breeden warned Thursday that hedge funds’ expanding role in government bonds may make localized market stress more likely to spread to other markets.

She spoke in Bangkok during the annual meetings of the International Monetary Fund and World Bank. She described a years-long shift in core government bond markets: insurers and pension funds now make up less of the investor mix, while hedge funds that respond to price moves and operate internationally have become more prominent.

“The likelihood of a shock in one market transmitting to another is greater than what it was,” Breeden said. She said the changing investor mix raises the chance that turbulence in one market will spill into others.

Hedge funds have about $13 trillion in gross assets globally. Their activity can support market liquidity and efficiency, but leverage used to boost returns and crowded trading strategies can magnify stress during turmoil. Those strains can reach broader financial markets, including banks’ prime brokerage businesses. Leverage can amplify the effect of price swings, while crowded strategies may leave many funds exposed to similar moves.

The Treasury basis trade illustrates how leverage enters bond markets. Funds buy U.S. Treasury bonds in the cash market and sell futures tied to those securities, seeking to profit from a small difference between their prices. Borrowing can increase the returns sought from that gap, while also making market stress more consequential for the positions. Interest in the strategy has sharpened after this year’s sovereign-debt sell-off, alongside scrutiny of hedge funds’ Treasury holdings.

Recent yield moves show the broader market backdrop. Yields on 10-year and 30-year U.S. Treasurys reached their highest levels since 2002 earlier this month. Yields on 10-year U.K. government bonds, known as gilts, also touched multi-decade highs. French government bond yields, known as OATs, climbed sharply in recent weeks amid concern about the country’s fiscal outlook.