A regulatory crackdown on the so-called basis trade, a hedge fund strategy that looks to exploit price differences between Treasury futures and bonds, could cause a “significant” hit to short-dated credit markets, according to strategists at UBS Group.
The report cites UBS analysts Michael Cloherty and Matthew Mish in suggesting that if regulators move to cap hedge fund leverage, for example, many managers would exit the trade causing an increase in the relative cost of Treasury futures.
Asset managers who use these futures to replicate Treasury performance and free up cash for corporate bonds would then need to switch to buying cash Treasuries instead of corporate bonds, causing “significant spillovers” for the short-dated credit market, UBS warned.
In a note to clients, Cloherty and Mish said: “Any increase in costs for the hedge funds taking the other side of this trade can raise costs for the real money investors.
“Eventually, if costs get too high, real money investors will look to unwind both the futures and the credit leg of the trade.”
The basis trade, which employs high levels of borrowing, has attracted the attention of regulators due to its role in the market turmoil that ensued at during the outbreak of the Covid-19 pandemic in 2022. Problems arise with the strategy when unexpected events like the pandemic lead to market volatility and funds offload their holdings en masse.
According to a Federal Reserve study in March, hedge funds have accumulated at least $317bn in basis trade Treasury holdings since Q1 2022.
