Hedge funds have bet big on our bonds, and it’s a gamble that could cost us dear

Sarah Breeden, deputy governor for financial stability at the Bank of England, delivered a sobering and important speech last week on where the next financial crisis might come from. Her suggestion that global stock prices might fall back sharply from all-time highs garnered the most attention, but she also highlighted something else that shouldn’t be overlooked: big changes are afoot in the UK government bond market. And they have consequences for us all.

It’s useful to start with some background. There has been an enormous shift in recent years in who buys UK government debt. Traditionally, the biggest and most important buyers of UK government bonds – known as gilts – were UK-based pension funds and insurance companies. From the Treasury’s perspective, these were great buyers to have: they’d buy whatever the price, almost, and they’d typically hold on to those bonds for decades. During the 2010s, the Bank of England was another big buyer of gilts, via its quantitative easing programme, and was also insensitive to price.

Things have changed. Pension funds are shrinking their holdings. The Bank is now selling, rather than buying. In its place, we’re increasingly reliant on buyers who are rather more discerning on price and rather less attached to the UK: asset managers, hedge funds, commercial banks and foreign investors. They’ll buy gilts, sure – but only if the price is right.

Then, layered on top, there is the change the Bank is concerned about. In the past couple of years, hedge funds have been taking increasingly large, increasingly leveraged positions in relation to UK gilts, making use of what’s called the gilt repo market. In plain English, they sell a gilt to someone else (typically a bank) for cash, with a promise to buy it back (repurchase, hence “repo”) later. They use that cash to buy more gilts, and repeat the process. This allows them to use borrowed money to super-size their positions, whether they are betting on movements in interest rates or exploiting tiny price gaps between financial assets. A relatively small number of firms have been pursuing a similar strategy, says Breeden.

When those bets start to go wrong (ie they start losing money), the hedge funds look to cut their losses by unwinding their position (selling up). But if everyone is rushing for the exit at once, things can get messy. The initial shock gets amplified and the market becomes more volatile. We saw this earlier in the year, with some very big swings after the attack on Iran upended expectations of interest rate cuts – though the market successfully handled this without a 2022-style meltdown, and without the Bank having to activate its emergency facilities. This is good news, but regulators at Threadneedle Street are sufficiently worried to be exploring whether policy reforms are needed to put more of a lid on leveraged risk-taking.

These developments matter for the real economy. Household mortgage rates are tied to gilt yields, and when the gilt market goes haywire, mortgage products get withdrawn. More than 600 products (about 10% of the total) were withdrawn in a single week amid the volatility of early March, according to Moneyfacts, and the shelf-life of mortgage products has plunged. Firms also often have their financing costs tied to those of the government. And, needless to say, a full-on financial crisis would be bad news more generally.

These are structural changes, not easily or quickly unwound. We need to adjust to a new normal where the government will need to offer higher yields to find buyers for its debt, and we should probably expect those yields to be more volatile – including in response to political events. We could reduce our vulnerability by borrowing less, or perhaps by thinking creatively about how to increase our domestic buyer base (war bonds, anyone?). But I suspect that bond market vulnerabilities will loom ominously over our politics for a long time yet.

Photograph by PA Images / Alamy