Analysis-Hedge fund dominance latest risk for febrile UK debt markets

A second bet, that UK inflation will remain high, involves shorting 10-year gilts and buying two-year bonds.

A third trade has seen trend funds put on bets against 10-year gilts for seven out of the past nine weeks, JPMorgan data from March 17 shows.

Such trades are only a slice of hedge funds’ individual portfolios but their combined impact has raised concerns.

The sources all said that, to fund their gilt positions, hedge funds are using up a disproportionate share of borrowing available in the UK repo market, a key part of the financial system’s plumbing.

Jillien Flores, chief advocacy officer at the Managed Funds Association, said diversity of participants helped improve liquidity and market efficiency, adding: “Alternative asset managers help reduce the cost of UK government borrowing through their participation in the gilt market.”

Exclusive data from S&P Global Markets for Reuters shows average use of repo on 10-year gilts over a year-high in February.

Repo markets allow the holder of a bond to lend it out temporarily in exchange for cash, a quick and cheap way of borrowing. Typically banks lend bonds to hedge funds, pension funds, large corporations and each other.

The BoE warned in November that hedge funds’ rising share of repo borrowing could deprive other institutions of funding, especially if banks lend less during spells of market stress.

Among those vulnerable to gilt selloffs are pension schemes, which borrow in repo markets to finance hedging positions. These derivatives contracts require more cash to secure them when gilt yields rise, which if the repo market is tight can trigger fire sales of liquid assets – including gilts, accelerating the selloff.

“This is where a market selloff can start,” said Andy Hill, managing director at the International Capital Markets Association.

“You need the repo market to work. There is the risk that, in highly volatile times, as balance sheets become more expensive, banks might step away from intermediating.”

When gilts sold off in January, pension funds posted 3 billion pounds ($3.9 billion) in extra collateral, said a BoE blog on March 6.

To ease that risk, the BoE has developed a new liquidity facility for gilt holders like insurance companies and certain pension schemes, but to apply they must hold at least 2 billion pounds worth of UK bonds.

The March 26 release of official growth and borrowing forecasts is seen as the next big test of UK market sentiment.

James Athey, fixed income manager at Marlborough, warned of disruption if hedge funds rush to the exits.

“When you have market shocks and changes, rapid unwinds of positions because of these changes can escalate and cause stability issues,” he said.

($1 = 0.7704 pounds)

(Additional reporting by Yoruk Bahceli; Editing by Dhara Ranasinghe, Elisa Martinuzzi and Catherine Evans)