Hedge funds face backlash from Europe in bond market

The pushback was prompted by unusually large orders placed by hedge funds for new bonds, which can then potentially be sold—sometimes within hours—to the European Central Bank for a profit, bankers, investors and a government official said. Order books, which track demand for new bonds and help determine the prices, have ballooned since hedge funds began to pile into this trade.

The debt-management offices of Spain and Italy have placed caps ranging from 500 million euros to 1 billion euros, equivalent to $608 million to $1.2 billion, on orders from hedge funds for bonds directly issued by countries in the primary market, according to bankers who worked on the deals. France has also limited order sizes, an official said.

Millennium Management, Brevan Howard, DoubleLine, Tenaron Capital Management and BlueBay Asset Management are among the hedge funds that have been active in the primary market for sovereign bonds in recent months, according to bankers. Some hedge funds have put in orders for as much as 3 billion euros of bonds in a single offering, which is far more than they can realistically buy, the bankers said.

Large investment firms, pension funds, insurers and banks’ treasury departments are usually the biggest buyers of government bonds in the primary market. Countries issuing bonds typically seek to avoid investors with a short-term horizon. That is because hot money flowing quickly in and out of their debt can make prices volatile and potentially drive away other buyers, which could increase their borrowing costs.

Hedge funds became bigger players in Europe’s sovereign bond market after the ECB last year put forward a program to buy up to 1.85 trillion euros of debt to backstop credit markets, and have stepped up their activity in 2021. The central bank only purchases government bonds in the secondary market, creating an opportunity for investors to buy bonds directly from the governments and sell them to the ECB.

In October, the first issuance of European common debt attracted an unprecedented 233 billion euros in orders, according to the European Commission. That was the most ever in records dating back to 2003. Around 80% of the bids were from hedge funds, according to a banker who worked on the deal. The commission, which is the executive arm of the European Union, ultimately raised 17 billion euros.

Banks that run debt sales for governments tend to allocate less than 10% of an issuance to hedge funds. The firms typically receive only around 1% of what they offer to buy, which encourages them to place large orders, according to bankers. That means an offer to buy about 2 billion euros in bonds could net the hedge funds about 20 million euros of the securities.

The recent surge of interest from hedge funds in the primary market is making it difficult to price the bonds, as it is more difficult to gauge the real demand, said Benjamin de Forton, a debt-capital markets director at BNP Paribas.

For instance, Spain attracted 130 billion euros of orders for a 10-year bond offering in January. But as bankers hammered out the final terms of the sale and the proposed price climbed, demand for the bonds abruptly halved. That was because hedge funds pulled their orders as their already slim profit margins shrank, bankers said. The government ultimately raised 10 billion euros, with the bulk of the buyers being traditional asset managers. Hedge funds got about 5.5% of the bonds sold, bankers on the deal said.

“Swift moves in fast-money account orders have meant new-bond execution was at times potentially more challenging," Mr. de Forton said.

BlueBay is willing to purchase all the bonds it offers to buy, a spokeswoman said in response to a request for comment. Millennium and Brevan declined to comment. DoubleLine and Tenaron didn’t respond to multiple requests for comment.

France’s debt management office asked banks in March to hold talks with hedge funds to encourage them to put in smaller orders, according to Anthony Requin, chief executive of the agency. Firms that put in unrealistically large orders would be penalized with a smaller allocation than other firms that put in more “reasonable orders," he said.

“The relationship between what could be considered as a good transaction and the sheer size of the order book is broken," said Mr. Requin. “One may be confronted with a skyrocketing order book, but which is in fact of poor quality. In that case, tightening the price might be challenging or risky if you are targeting a transaction of [a] certain size."

Italy and Spain’s debt management offices didn’t respond to requests for comment.

Hedge funds have sought to turn profits from central bank stimulus programs previously. The Federal Reserve’s Troubled Asset Relief Program during the 2008-09 financial crisis drove distressed-debt investors to snap up assets such as mortgage-backed securities and U.S. bank debt cheaply and sell them onto the Fed. The corporate-bond market in Europe is another area where this trade happens, as the ECB also buys investment-grade corporate debt to support the market.

Despite the small allocation sizes and the narrow profit margin from reselling the bonds to the ECB, sovereign bond sales have grown attractive for hedge funds because they are sometimes able to make a quick profit. Leveraging, or using borrowed money to make purchases, can in many cases amplify returns.

Some hedge funds borrow money from their prime brokers, which are divisions within investment banks that provide financing for trading clients, to place bets that are leveraged up to five times on such deals, according to one investor. That means that for every one that the hedge fund invests, its prime broker has contributed another four euros, allowing them to buy more bonds without tying up their own capital.

In 2021, sizable drops in demand hit a 4 billion euro Austrian bond issuance in January, a 14 billion euro Italian debt sale in February and a 6 billion euro Spanish issue in April, bankers said.

The heightened interest from hedge funds in new sovereign debt is likely to continue because the ECB increased the pace of its bond purchases in March, bankers said. Governments that haven’t limited participation are likely to continue to see inflated order books and riskier deals, they said.

This story has been published from a wire agency feed without modifications to the text.