Hedge funds, including Brevan Howard, Capula and Millennium, have upped their leveraged bets on UK government bonds, amplifying concerns over potential instability in the gilts market, a key benchmark for UK borrowing costs, according to a report by Reuters.
The report cites unnamed market sources as highlighting that hedge funds now account for 60% of UK bond trading volumes, up from 53% at the end of 2023 – a trend that has drawn scrutiny from the Bank of England (BoE) and regulators.
BoE Governor Andrew Bailey recently cautioned that hedge fund activity could “propagate liquidity stress” in UK markets, particularly due to their heavy usage of short-term lending in repo markets. Repos (repurchase agreements), a key funding mechanism, have become crucial for hedge funds deploying a range of high-leverage bond trades.
Market sources indicate hedge funds are among the most active players in gilt repo financing, and are currently deploying three main strategies in UK gilts: basis trade arbitrage, whereby speculators buy futures contracts on 10-year gilts while shorting the cash bond, exploiting a pricing discrepancy; inflation trades, whereby funds are shorting 10-year gilts while buying two-year bonds, betting on persistent UK inflation; and momentum-based shorting, which has seen trend-following hedge funds short 10-year gilts for seven of the past nine weeks, according to JPMorgan data.
While these positions represent only a portion of each fund’s portfolio, their combined scale is stretching repo market capacity – raising concerns over liquidity during times of market stress.
The increasing concentration of hedge fund borrowing in UK repo markets has broader systemic implications. The BoE has warned that other financial institutions, including pension funds and insurers, could be squeezed out of repo borrowing – potentially triggering forced asset sales if liquidity dries up.
In January, a gilt market selloff forced UK pension funds to post £3bn ($3.9bn) in additional collateral, exacerbating concerns about repo market fragility. To mitigate this risk, the BoE has introduced a new liquidity facility for gilt holders, though eligibility requirements limit access to institutions holding at least £2bn in UK bonds.
