By Alun John and Dhara Ranasinghe
LONDON, Oct 16 (Reuters) - A sharp selloff in European government bonds this month shows how hedge funds' growing role is making a systemically important market more vulnerable — a risk regulators are watching closely.
On the surface, the reasons for a surge in French 10-year yields to 24-year highs were clear: a growing government debt burden, inflation fanned by high energy costs, and competition for capital from a global data-centre boom that is lifting economic
growth.
But some investors said the scale and speed of the moves showed hedge funds were fuelling volatility in the market as they rapidly unwound trades.
No obvious trigger preceded the unusually large daily yield increases of over 10 basis points (bps) and nearly 25 bp two-day jump in the premium investors demand to hold French debt over German bonds, the most since the euro zone debt crisis. Yields rise as bond prices fall..
The European Central Bank estimates that hedge funds account for more than half of trading in the roughly $13 trillion European government bond market, up from 30% in 2020. The International Monetary Fund says hedge fund exposure to sovereign bonds has more than doubled since 2022, without giving a total.
"The hedge fund community has ballooned," said Lauréline Renaud-Chatelain, fixed income strategy lead at Pictet Wealth Management. "It's bringing a lot more volatility to the bond market and potentially explains why the (French) sell-off was severe in a context where we lacked a real catalyst."
HEDGE FUNDS CAN AMPLIFY PRICE MOVES
Hedge funds oversee over $40 trillion, including the borrowed funds they use to leverage their bets and exposure through derivatives, according to the IMF. They rarely share details of their investments and will bet on asset prices falling as well as rising.
Their role in sovereign debt trading matters because it impacts governments' funding, which in turn can affect borrowing costs for companies and homeowners.
Increased hedge fund trading activity can "amplify price dislocations and liquidity strains during periods of stress," the IMF said in October. It cited hedge funds' borrowing and crowded trades, in which many funds hold similar positions.
The European Securities and Markets Authority, the region's financial watchdog, declined to comment for this story.
Certain strategies popular with hedge funds are sensitive to price and volatility changes, said Bruno Schneller, managing partner at Erlen Capital Management, which invests in hedge funds.
These include cash-futures basis trades and leveraged carry trades. In a basis trade, hedge funds seek to profit from the narrow price difference between bond securities and futures. A carry trade involves borrowing cash in a currency with low interest rates to bet on other assets.
When things change, "investors may need to reduce exposure relatively quickly ... creating the potential for market moves to become self-reinforcing," said Schneller.
But he cautioned against attributing the recent volatility solely to hedge funds given fundamental drivers, notably in France.
Political jostling ahead of 2027's presidential election could hinder efforts to reduce France's high deficit, one factor which has rattled markets.
HEDGE FUNDS STEP IN AS OTHER INVESTORS DRAW BACK
Jiri Krol, global head of government affairs at the Alternative Investment Management Association, a private markets industry group, said hedge funds were one of bond markets' most important sources of liquidity.
"As for recent market dynamics, we caution against hasty, broadbrush pronouncements based on anecdotal evidence about the role of particular categories of market participant," he said.
Hedge funds have taken a greater share of government bond markets as other buyers retreat. Central banks are shrinking balance sheets, changes in pension schemes are reducing demand for sovereign debt, and regulatory rules mean banks can hold fewer bonds.
Their participation can help markets function smoothly in an era of increased government borrowing, while their more frequent trading activity boosts liquidity.
"Everyone kind of appreciates the role hedge funds play," said Marion Le Morhedec, Fidelity International's chief investment officer, fixed income.
But popular hedge fund trades are crowded and are typically funded by debt, while funds' short-term focus means they can suddenly exit en masse if markets move against them, draining liquidity and exacerbating price moves.
Hedge funds "completely wipe out the market in those circumstances," Le Morhedec said. "For me, 100% of the explanation (of early October's low liquidity) is this."
Asked about the systemic threat posed by hedge funds, the chief financial officer of Wall Street giant JPMorgan told analysts on Tuesday the industry has been "a source of risk for the system for a long time now, and everyone knows that, including the hedge funds themselves".
Their leverage is "in the category of known unknowns," Jeremy Barnum said. "It doesn't mean it's riskless, but we kind of know what it is."
ON WATCH
In early October, short-dated debt was particularly volatile. France's 2-year bond yield surged, Germany's plunged on safe-haven inflows and the gap between the two widened 21 bps, the most in a day since 2012.
Hedge funds often use French government bonds as collateral when borrowing to fund their bets. French debt makes up about €100 billion ($112 billion) of the €250 billion in euro zone government bonds that have been pledged for borrowings in the repo market, Bank of France data shows.
The Bank of England is also watching the repo market, a crucial source of funding for financial firms at times of stress. It estimates £85 billion ($113 billion) of the £200 billion net borrowing in gilt repo markets is from hedge funds.
One big European bond investor told Reuters that hedge funds' role has become a key topic for regulators when they meet with the firm.
Pictet's Renaud-Chatelain said liquidity in French bonds in early October had been the worst since 2008.
Poor liquidity makes trading harder and brokers charge more. In extremis, they may not provide prices at all, causing markets to seize up.
A separate IMF report on Tuesday said markets have managed recent stress well, however, and the half-dozen fund managers Reuters spoke to said that in general the volatility had not yet affected their strategies, and at times created opportunities.
"Volatility sometimes is good ... (French debt) became relatively cheap compared to the credit risk," said Michela Bariletti, chief credit officer at Standard Life. "We look at OATs (French bonds) cautiously but during the sell-off, we actually added a bit."
($1 = 0.8929 euros)
($1 = 0.7543 pounds)
(Reporting by Alun John and Dhara Ranasinghe, Additional reporting by Yoruk Bahceli and Harry Robertson, Editing by Elisa Martinuzzi and Catherine Evans)
