Debt Chiefs Tout Benefits of Hedge Fund Growth in Bond Markets

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(Bloomberg) — Some sovereign debt chiefs are warming up to the growing footprint of hedge funds in government bond markets, casting these investors as potentially beneficial participants rather than a source of risk.

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The heads of the Canadian, German and Italian government debt offices said the more active role now being played by hedge funds is benefiting liquidity and market functioning. The remarks, at the FT Global Bond Summit in London on Tuesday, follow recent concerns from various regulators about the risks to financial stability from leveraged hedge fund strategies.

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“A year or so ago, we were fairly concerned, but our views have evolved and they’re more nuanced now,” said Matt Emde, director general for funds management at the Government of Canada’s department of finance. “It’s added depth to our markets, and we’re getting better pricing interactions because these hedge funds have been bidding very aggressively, they want the volumes.”

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Emde said that hedge funds currently make up 30%-50% of demand in Canadian debt auctions. He likened their role to “shadow dealers,” given their tendency to warehouse the bonds for some time before selling them in the secondary market, boosting liquidity for other types of investors.

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The greater involvement of such funds has led regulators from Canada to the UK to warn it could increase volatility or make markets more vulnerable to sudden selloffs. In the UK, where hedge funds control more than half of electronically traded gilts, Bank of England Governor Andrew Bailey said earlier this year that a small number of funds using borrowed cash could risk destabilizing the market if they unwound their positions simultaneously.

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Tammo Diemer, a member of the executive board at the German Finance Agency, told the conference that hedge funds are now playing a similar role to proprietary trading desks at banks, which have been scaled back due to regulatory changes. He added the market is benefiting from certain strategies such as relative value trades between different products and countries.

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While Italy’s debt boss agreed that hedge funds are performing useful functions such as closing price arbitrages, he sounded a note of caution.

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“It’s clear that they may also represent a social risk, especially in the context of market instability,” said Davide Iacovoni, director general for public debt for the Italian finance ministry. 

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With sovereign borrowing costs having surged after the pandemic and then again on the war in Iran, the pressure on government budgets means many are paying closer attention to any potential systemic risks. In 2022, a historic rout in UK bonds led to the ouster of former Prime Minister Liz Truss.

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Going forward, the officials said it’s important to better understand how to interact with hedge funds and the different types of strategies they run.

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“You can’t paint all hedge funds with the same brush. You have to get to know who they are,” said Emde. “The flip side is that not all central banks and these other institutions are safe hands.”

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