Hedge funds have increasingly engaged in debt-fueled bets on UK government bonds, raising concerns about potential instability in the gilts market, which serves as a benchmark for borrowing costs in Britain, including mortgages. Bank of England chief Andrew Bailey emphasized in February that non-bank institutions like hedge funds can exacerbate liquidity stress in core UK financial markets, particularly the gilt market.
This concern stems partly from their activities in short-term lending markets, as described by portfolio managers, hedge fund executives, and a former central banker. Hedge funds borrow to support various trades based on 10-year gilts, and data from electronic trading platform Tradeweb indicates they accounted for 60% of UK government bond trading volumes in January and February, an increase from around 53% at the end of 2023 and at least a five-year high.
David Aspell, a senior portfolio manager at Mount Lucas Management, stated that the UK rates markets can trade chaotically because large hedge funds exert significant influence, and there may not be substantial real money relative to the hedge funds at times. With approximately £2.5 trillion ($3.2 trillion) of debt outstanding, the gilts market is modest compared to the $28 trillion market for U.S. Treasury bonds. Volatility in bond markets impacts government borrowing costs and credit conditions for households and businesses.
Hedge fund involvement in European bond markets has increased recently, and while their positioning occasionally raises alarms, some officials argue they contribute positively. However, UK regulators are scrutinizing how hedge funds utilize repo markets to position in gilts. Repos, short for repurchase agreements, are crucial funding sources during times of stress.
Several hedge funds active in gilt markets, including Brevan Howard, Capula Investment Management, Millennium Management, and Rokos Capital Management, employ a mix of asset classes under one roof, but they declined to comment. Sources indicate that hedge funds currently employ repo financing for three distinct strategies against gilts: one involves exploiting price differences between 10-year gilt prices and their futures by buying futures trading at a premium and shorting the cash bonds; another focuses on expectations of sustained UK inflation by shorting 10-year gilts while buying two-year bonds; and a third trade has seen trend funds betting against 10-year gilts for seven out of the last nine weeks.
While these trades represent only a fraction of hedge funds' individual portfolios, their combined effects have raised concerns. Sources noted that hedge funds are consuming a disproportionate share of borrowing available in the UK repo market, a vital component of the financial system's infrastructure. Jillien Flores, chief advocacy officer at the Managed Funds Association, argued that the diversity of market participants enhances liquidity and efficiency, highlighting that alternative asset managers play a role in reducing the cost of UK government borrowing.
Exclusive data from S&P Global Markets revealed an increase in the average use of repo on 10-year gilts, reaching a one-year high in February. Repo markets enable bondholders to lend their bonds temporarily in exchange for cash, providing a quick and inexpensive borrowing option. Typically, banks lend bonds to hedge funds, pension funds, and large corporations.
The Bank of England warned in November that hedge funds' growing share of repo borrowing could hinder other institutions' access to funding, especially if banks reduce lending during periods of market stress. Pension schemes are particularly vulnerable to gilt sell-offs as they rely on repo markets for financing hedging positions. As gilt yields rise, these derivatives contracts require additional cash, which can lead to forced sales of liquid assets, including gilts, if the repo market tightens.
Andy Hill, managing director at the International Capital Markets Association, noted that instability could stem from rapid unwinds of positions during market shocks. The repo market must function smoothly; otherwise, banks might retreat from intermediation in volatile conditions. When gilts experienced a sell-off in January, pension funds were required to post £3 billion ($3.9 billion) in extra collateral.
To mitigate such risks, the Bank of England has developed a new liquidity facility for gilt holders, such as insurance companies and specific pension schemes, which must hold at least £2 billion worth of UK bonds to qualify. The upcoming release of official growth and borrowing forecasts on March 26 is anticipated to be a significant event.
James Athey, a fixed-income manager at Marlborough, cautioned that disruption could occur if hedge funds rapidly exit their positions. He warned that in the face of market shocks, swift position unwinds could escalate and create stability issues.