Savior or source of volatility? Hedge funds emerge as 'wild card' in US Treasury market

With 10-year Treasury yields topping 5% and alarm bells ringing across financial markets, hedge funds are emerging as a 'wild card' in the US government bond market. As pension funds retreat from Treasuries, hedge funds have moved in to fill the gap — prompting both optimism that they are adding liquidity and making bonds easier to trade, and concern that their short-term investment tendencies could amplify volatility. The Federal Reserve Bank of New York has launched a probe into what impact hedge funds' rising prominence may have on the Treasury market.

The Treasury market has long been a destination for pension funds seeking stable, long-term returns. But US government bonds have fallen sharply out of favor with those investors in recent years. According to research by the Centre for Economic Policy Research in Paris, US pension funds once allocated as much as 40 percent of their assets to bonds, but have since cut that share to between 10 and 15 percent. European pension funds have similarly reduced their bond allocation from 35 percent to around 20 percent. Over the past year, major pension funds in Denmark, the Netherlands and Australia have also trimmed their US Treasury holdings. Norway's sovereign wealth fund — the world's largest, managing more than $2 trillion in assets — said earlier this month it would reduce its allocation to government bonds, including US Treasuries, and shift into other products such as mortgage-backed securities.

Hedge funds have stepped into the space vacated by pension funds, taking the opposite path by increasing their exposure to US Treasuries. According to the US Treasury's Office of Financial Research, hedge funds held approximately $2 trillion worth of US government bonds as of early this year — more than double their holdings from five years ago, giving them a 7 percent share of the entire US Treasury market.

One driver of hedge fund buying is the basis trade, a strategy that seeks to profit from small price differences between Treasury bonds and futures contracts. Basis trading did not grow significantly in the first and second quarters, but the volume involved is still considered substantial.

The sheer scale of hedge fund Treasury holdings underscores how significant their role in the market has become. The Wall Street Journal noted that their role amounts to a "wild card" — an unpredictable variable — particularly given the excessive leverage hedge funds often employ to amplify their bond bets.

With Treasury yields having risen sharply, some market participants argue that hedge funds could actually benefit the bond market by adding liquidity and making it easier to buy and sell bonds.

Robert Tipp, head of global bonds at PGIM, the asset management arm of insurer Prudential, said hedge funds are "playing a useful role." When some long-term investors seek to execute interest rate swap transactions, hedge funds are willing to take the other side of those trades, he said. The European Central Bank has also said that hedge fund demand helps ensure government bond auctions proceed smoothly.

However, concerns persist that hedge funds' pursuit of short-term gains could destabilize the US Treasury market. The ECB, while acknowledging their positive contributions, warned that volatile investors such as hedge funds could amplify market stress if they rush to sell bonds to unwind large positions.

Apparently with those risks in mind, the Federal Reserve Bank of New York has begun examining whether hedge funds pose a risk to the US Treasury market. The Wall Street Journal, citing people familiar with the matter, reported that staff at the New York Fed's markets group have in recent weeks been probing hedge funds' growing role in the Treasury market, interviewing investors as part of the effort. Representatives from foreign central banks and the IMF are also conducting their own research into the expansion of hedge funds in the US Treasury market, those people said.