Last week, heavily leveraged bond trades were unwound in a spectacular fashion.
And while the worst might be behind for now, I don’t see a structural fix to this bond market imbalance.
There are two very popular, heavily leveraged trades in bond markets: swap spreads and basis trades.
Both involve going long the cash Treasury bond, and going short something against it: the basis trades uses the Treasury future as short leg, and the swap spread uses interest rate swaps.
In both cases, the trades involve a large use of leverage because the purchase of the cash Treasury bond is financed using the repo market: for a $100M trade in basis or swap spreads, due to repo market funding hedge funds must only use a tiny portion (~2-5%) of the needed capital to enter the transaction.
Let’s focus on the swap spread trade for a second.
As long as repo markets remain orderly, investors can use it to fund purchases of 30-year US Treasuries, pay a fixed 30-year interest rate swap against it and earn a whopping 90 (!) bps per year in ‘’swap spreads’’ - see chart below.
But why on earth would investors be able to earn such a premium on US government bonds?
It’s because of regulation and the growing supply/demand imbalance problem in US Treasury markets.
Bank regulation has crippled the ability of market makers to warehouse risks, which means their ability to absorb large issuance of Treasuries on their balance sheet has diminished.
On top of it, Treasury departments of US banks are penalized for owning large amount of Treasuries from regulations like the Supplementary Leverage Ratio (SLR) which don’t exempt USTs from its calculations.
All of this is happening at a time when the supply of US Treasuries has dramatically grown because of persistent budget deficits, forcing dealers to swallow bonds at auctions and testing their limits.
Given the supply/demand imbalance, the marginal buyer of US Treasuries tends to be the leveraged hedge fund which gets involved in basis or swap spread trades and demands a hefty premium as compensation.
And this fragile system holds until it doesn’t.
In the last 10 days, several hedge funds were hit by margin calls given turbulent markets.
To meet these margin calls, they had to de-risk their portfolios and sell every asset they could – including Treasuries.
As Treasuries got caught in the deleveraging mania, basis trades and swap spreads suffered.
The first stop losses in these highly leveraged trades were hit, and then a self-fulfilling VaR shock occurred.
All hedge funds involved in the same trade had to deleverage at the same time without a marginal buyer of last resort.
Ouch.
And it’s not clear how this problem will get structurally fixed - so watch out!