Hedge funds’ business models can explain why they are the only investor type that increased bidding amid higher debt issuance. Essentially, the broad approach hedge funds take is to:
- identify a perceived mispricing in the market
- take a large position on that perceived mispricing—as seen in hedge funds’ substantial use of leverage using repos
Hedge funds often use relative value strategies, trading on the perceived mispricing between GoC bonds and either:
- futures (cash-futures basis trade)
- swaps (asset swap trade) of a similar term
- provincial or mortgage bonds denominated in Canadian dollars or other sovereign bonds (cross-market trade)
Hedge funds also commonly use strategies based on macroeconomic views (e.g., position on level or shape of the yield curve) or bond pricing at time of auction.
Because the GoC bond market is relatively liquid and efficient, smaller mispricing opportunities can mean that hedge funds need to take larger positions to achieve their desired return. In the cash-futures basis trade which involves a long position in a GoC bond and a short position in a GoC futures contract, hedge funds use leverage to amplify their profits as the spread between the two securities is small (Uthemann and Vala 2024).
Higher issuance volume makes it easier for hedge funds to take larger long positions. This is because it:
- increases available bonds to hold for those positions
- gives the hedge funds a larger base of assets to repo out to fund their positions
As well, a larger known future supply event (i.e., auction) for GoC bonds can facilitate larger short positions. That’s because the bigger supply allows hedge funds to obtain the required bonds more easily in the repo market. Further, when the GoC bonds are more liquid, the transaction costs for entering and exiting positions are lower.
Accordingly, the rise in GoC bond issuance has coincided with increased hedge fund borrowing against GoC bonds in the repo market to fund their relative value strategies (Bank of Canada 2024). In 2024, the Canadian Overnight Repo Rate Average (CORRA) persistently rose several basis points above the Bank’s target for the overnight rate. This indicated that hedge funds were holding large, leveraged long bond positions. But the opposite was seen with short positions in 2023 (Plong and Maru 2024a).
Regardless of a hedge fund’s specific strategy, the primary market tends to be a cost-effective way to attain these GoC bond positions in large volumes. Purchasing at auction avoids the price impact that can come from buying or selling a large volume of bonds in the secondary market, and auction yields are often slightly higher than prevailing secondary yields. In addition, some strategies (such as auction-based strategies) rely directly on significant primary market participation.
Chart 2 shows the strong positive relationship between hedge fund bidding (as a share of total bidding) and total GoC bond stock since 1999.