Commentary on Political Economy

Wednesday 12 May 2021


Hedge Funds Are Guarding Against a Bond Tantrum

While the reflation debate rages, traders are acting. They’re running their biggest short positions against junk bonds for more than a decade.

There, there.
There, there. Photographer: Tomohiro Ohsumi/Getty Images

As the debate rages about whether surging commodity prices, rebounding economies and fiscal stimulus will spark a sustained acceleration in inflation, government bond yields have been slowly but surely heading higher.

In the riskier corners of the debt market, hedge funds are taking some chips off the table to defend themselves in case of a full-blown bond market tantrum. It’s a smart move given the unusually febrile economic and market environments. 

With prices of everything from lumber to iron ore to copper surging, investors are increasingly wary that the prospect of a persistent rise in consumer prices will prompt central banks to scale back their respective bond-buying programs, purchases that have helped drive government borrowing costs ever lower. So benchmark debt has started to suffer in anticipation of that support being trimmed back.

In the U.S. Treasury market, 10-year yields have almost doubled since the start of the year to reach 1.6%, triple the low reached in August last year. U.K. yields have quadrupled to 0.8% since January, while German yields are at -0.2%, up from -0.6%.

Heading Higher

Government debt yields have climbed this year

Source: Bloomberg

But it’s in the more speculative corners of the market where hedge funds have really started to bet that the good times may be about to come to a crashing end. Investors are currently running short positions on $55 billion of global high-yield debt, up from $35 billion at the beginning of the year, according to IHS Markit Ltd. data cited by my Bloomberg News colleagues Laura Benitez and Tasos Vossos. That’s the industry’s biggest collective bet against junk bonds since 2008.

Hedge funds have currently borrowed some $30 billion of European investment-grade debt to sell in anticipation of profiting from declining prices. That’s helped push almost half of the region’s new 2021 bonds sold by non-financial companies with ratings higher than junk below their initial selling prices.

To be sure, we’ve seen this movie before at least a couple of times in the past decade or so, and it didn’t end well for traders who bet on lower bond prices. In the wake of the global financial crisis, central banks began to pump money into the banking system through what were then newfangled quantitative easing programs. Many market participants predicted such unprecedented pump-priming was bound to unleash higher consumer prices — and that benchmark U.S. yields, at their lowest levels in more than half a century, were unsustainably low.

In December 2000, with the 10-year Treasury yielding about 3.3%, buying U.S. government debt was deemed “a suicidal investment” by Marc Faber, publisher of the Gloom, Boom and Doom report. A Bloomberg News survey of Wall Street’s 18 biggest bond-trading firms showed a consensus forecast for the yield to climb to 3.65% in the following year.

That didn’t happen. Instead, the Treasury yield spent most of the next six months between 3% and 3.5%, before dropping to finish 2011 at a bit less than 2%. It averaged 1.8% in 2012 and 2.3% in 2013, although by the end of that year it was back up to 3%. In the decade through the end of 2020, its average level was about 2.2% — and it ended the pandemic-plagued year at 1%.

But traders with long memories are mindful of the so-called taper tantrum of May 2013. Treasuries lost $1.5 trillion of value in a fortnight after then Federal Reserve Chairman Ben Bernanke first suggested the U.S. bond-purchase program would be scaled back. The benchmark yield soared by half a percentage point to end the month at 2.13%. Even a short-lasting spike in yields can ruin the year for a wrongly positioned hedge fund.

This time around, there’s a concern that the ultra-low yields on even the riskiest debt — global junk-rated debt offers about 4.3%, its lowest ever — make the fixed-income market more exposed than ever to any hint that central banks are preparing to scale back their support.

Record Low

After spiking at the start of the pandemic, the average yield on global high-yield debt has dropped to its lowest level ever

Source: Bloomberg Global High-Yield Index

The pandemic produced a supply-side shock, with global supply chains damaged, to coincide with the contraction in demand prompted by economic lockdowns. That demanded a robust response. So for once, it’s not all about monetary policy: With governments adding fiscal fuel to the reflationary fire, U.S. Treasury Secretary Janet Yellen warned last week that interest rates may have to rise, though she quickly denied she was calling for action from the Fed. 

Storied billionaires including Ray Dalio of Bridgewater Associates LP and Paul Singer of Elliot Management Corp. have warned in recent months that bonds don’t offer anything resembling a safe or sensible investment. With the smart money now lining up to bet against junk debt, the bond market looks increasingly vulnerable to a tantrum.  

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