The Bank of Canada (BoC) released a staff discussion paper, “Are Hedge Funds a Hedge for Increasing Government Debt Issuance?”.
This paper studies the rapid increase since 2019 of Government of Canada (GoC) debt issuance alongside greater hedge fund participation at GoC bond auctions. The research team found a systematic relationship between GoC debt stock and hedge fund bidding shares at auction and attribute this to hedge funds’ business models, which are based on volume and leverage.
The team used bid-level auction data and found that hedge funds are more willing than other investor types to buy bonds at lower auction yields (higher auction prices).
These two results help explain why GoC auction performance has remained steady despite greater issuance and affirm the importance of hedge funds in supporting Canada’s cost-effective debt distribution in recent years.
Hedge funds have the largest repo positions across asset managers, followed by pension funds. And while dealers have ready access to repos and can position for directional views on rates and curves, they are restricted by the balance sheet constraints of internal risk limits and bank regulation, the paper noted.
The researchers conducted a counterfactual analysis of the exit of hedge funds from auction, which further affirms the importance of hedge funds to GoC auction performance. However, the concentration of hedge funds represents a potential vulnerability because hedge funds have a greater flight risk relative to domestic real money investors and thus contribute to a potentially less stable investor base.
In a recent survey, the Bank of Canada noted that if the trade war causes a large spike in volatility, leveraged hedge funds might rush to sell their holdings, straining liquidity across core markets – most notably in the market for Government of Canada bonds where they have a large presence, wrote the Investment Industry Association of Canada in a summary.