Hedge funds face scrutiny over Europe’s bond selloff

Investors and regulators are taking a closer look at hedge funds after this month's sharp selloff in European government bonds. A Reuters analysis published Oct. 16 argues that their growing presence is making a systemically important market more vulnerable. The European Central Bank estimates that hedge funds now account for more than half of trading in the roughly $13 trillion European government bond market, up from 30% in 2020, Reuters reported.reuters.com

The selloff had clear underlying causes. France faces a growing debt burden, energy costs are pushing up inflation, and a global data-centre boom is competing for capital. Together these pushed French 10-year yields to 24-year highs. Some investors told Reuters, however, that the speed and scale of the moves showed hedge funds were adding to the volatility as they rapidly unwound trades. The French 10-year yield reached 4.994% on Oct. 2, its highest since 2002, as investors worried the government's budget would struggle to pass a fragmented parliament.live.euronext.com+1

Moves with no clear trigger

Reuters found no obvious trigger for several daily yield increases of more than 10 basis points. It also noted a nearly 25-basis-point jump over two days in the premium investors demand to hold French rather than German debt, the biggest such move since the euro zone debt crisis. Lauréline Renaud-Chatelain of Pictet Wealth Management said the hedge fund industry "has ballooned" and is bringing "a lot more volatility," and that French bond liquidity in early October was the worst since 2008.reuters.com

The International Monetary Fund said hedge funds' exposure to sovereign bonds has more than doubled since 2022. It warned that their trading can "amplify price dislocations and liquidity strains during periods of stress," pointing to their use of borrowed money and crowded positions. Hedge funds also commonly pledge French bonds as collateral. About €100 billion of the €250 billion in euro zone government bonds pledged in repo markets is French debt, according to Bank of France data. Even so, France's short-term funding markets have stayed largely stable.hedgeweek.com+1

Industry pushes back

Jiri Krol of the Alternative Investment Management Association, a hedge fund industry group, called hedge funds one of the bond market's most important sources of liquidity. He cautioned against "hasty, broadbrush pronouncements based on anecdotal evidence." Marion Le Morhedec of Fidelity International disagreed. She said that when funds exit together they "completely wipe out the market," and that this explains "100%" of early October's thin liquidity.reuters.com

On Tuesday, Oct. 13, JPMorgan Chief Financial Officer Jeremy Barnum told analysts the hedge fund industry has long been "a source of risk for the system." He called its leverage "in the category of known unknowns." The European Securities and Markets Authority declined to comment to Reuters. One large European bond investor said hedge funds have become a key topic in its meetings with regulators. Some managers saw an opening in the selloff. "During the sell-off, we actually added a bit," said Michela Bariletti of Standard Life.reuters.com