Hedge funds and their trading strategies in the Government of Canada bond market

Hedge funds are active in Canadian government bond markets and help improve market efficiency. But their trading strategies are not well understood. We offer insights into the range of strategies hedge funds use beyond the more commonly known cash-futures basis trade. We also explore the concentration of trading activity among a few large funds.

Hedge funds use sophisticated and high-risk, high-reward trading strategies to turn small market movements into returns for their investors. This generally helps improve efficiency and liquidity in markets.

But hedge funds borrow large amounts to invest—known as leverage—to boost their potential returns. This means that a mistake can turn a small move into a big loss and potentially lead to market-wide disruptions if hedge funds need to suddenly sell off their bonds.

Hedge funds are now among the most active players in the Government of Canada (GoC) bond market. They buy between 40% and 50% of new bonds issued by the federal government. They also actively trade GoC bonds in secondary markets, accounting for about one-third of trades between Canadian bond dealers and non-dealer clients.

However, their activities are mostly unregulated and less transparent to the public than those of traditional investors like mutual funds.

For all of these reasons, staff at the Bank of Canada have been paying close attention to these entities in recent years. While we’ve known for some time that hedge funds use a range of investment strategies, we can now estimate the trading volume of each strategy.

How hedge funds trade Government of Canada bonds

Hedge funds use many specialized investment strategies—or types of trades—to generate returns. These strategies distinguish hedge funds from other types of asset managers such as mutual funds. This is because their investors typically seek returns that aren’t connected to broad movements in bond and equity markets.

We see four main strategies where trades include a GoC bond. These strategies can be known as:

• Macro curve trades—these involve trading different tenors of GoC bonds, such as 2-year and 10-year bonds, to profit from changes in the slope, or shape, of the yield curve.
• Micro curve trades—these happen when GoC bonds with similar maturity dates—like two 10-year bonds maturing six months apart—are traded to capture price discrepancies between the two bonds.
• Credit spread trades—these involve trading GoC bonds against provincial, municipal or corporate bonds of the same tenor to benefit from relative changes in prices between bonds of different issuers.
• Other trades—these include trading GoC bonds against bond futures and interest rate swaps—known as cash-futures basis and swap spread trades—or against similar foreign sovereign bonds like US Treasuries to take advantage of global pricing gaps. These trades also include simple, outright positions in GoC bonds.

Bank staff have studied the use of cash-futures basis trades and found that this strategy is an important one for hedge funds. But, until now, we couldn’t assess the size and scope of other strategies.

The trading activity of hedge funds is diverse

To quantify hedge funds’ use of the different trading strategies, we analyze transaction data on Canadian bond markets from the Market Trade Reporting System, a database compiled by the Canadian Investment Regulatory Organization.

Since these data do not link hedge fund bond trades to specific strategies, we use an algorithm to detect pairs of trades that tend to be done together as part of a particular strategy. For example, a micro curve trade typically sees a hedge fund trade one GoC bond for another of the same tenor through a single investment dealer. We classify trades that the algorithm doesn’t match as other trades, which includes cash-futures basis trades.

Our results suggest that hedge funds don’t rely on one strategy more than the others. As Chart 1 shows, the share for each strategy is material: other trades are at just under 36%, micro curve trades are at almost 32%, macro curve trades are at 20% and credit spread trades are at 12%.

To double-check our math, we use the funding trades (where hedge funds borrow the cash and securities for leverage) that appear in the same dataset and get similar results. However, both sets of results don’t fully represent the positions taken by the hedge funds and the associated risks.

Identifying and quantifying different strategies is important because each strategy involves distinct risks that could come from, for example, liquidity constraints, a drop in bond issuers’ credit ratings or changes in interest rates. Understanding these exposures allows the Bank to more effectively monitor and respond to emerging financial risks.

Hedge funds’ trading activity in the Government of Canada bond market is concentrated among a few firms

We also find that hedge funds managed by a relatively small number of firms account for most of the trading volume (Chart 2). Micro and macro curve trades have the highest concentration, with the five largest firms (by trading volume) contributing almost 70% of trading activity. Although the concentrations of the top five firms in the other two strategies are somewhat lower, they’re still over 50%.

Beyond the largest 5 firms, we find that around 50 firms managing hedge funds are active in Canadian bond markets. These firms are typically based outside Canada.

The high concentrations suggest that if just one or two firms were to rapidly unwind their positions it could lead to a substantial and sudden spike in bond sales that could be a challenge for the market to absorb. Our results also suggest that market conditions that generate stress could affect many funds simultaneously through their common exposure to a given strategy.

The Bank’s work sheds light on the role of hedge funds in financial markets

Canada has historically had excellent data on bond markets. Without these data, information on activities of hedge funds in these markets would not have been easily accessible. Work at the Bank aims to expand data on hedge fund activities so we can continue offering new insights on markets critical to the Canadian economy.

Our recent work helps identify strategies where hedge funds borrow to fund their purchases of GoC bonds. Although these strategies can bring efficiencies, they could destabilize markets if hedge funds lose access to funding and need to quickly sell large quantities of bonds. Insights from work like ours help inform the Bank’s ongoing monitoring of financial risks in the bond market and contribute to productive discussion among market participants and financial sector authorities.

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