French Bond Sell-Off Puts Hedge Fund Influence Under Scrutiny

Hedge funds are facing increased scrutiny over their influence in European sovereign debt markets after a sharp sell-off in French government bonds raised concerns about liquidity and systemic risk.

French 10-year government bond yields reached a 24-year high in early October. The premium investors demand to hold French debt instead of German bonds recorded its largest two-day increase since the eurozone debt crisis.

Rising government debt, inflation and political uncertainty contributed to the sell-off. Investors indicated that the rapid unwinding of leveraged hedge fund positions may have increased the size and speed of the market moves. They cautioned that hedge funds were not the sole cause.

Hedge funds now account for more than half of trading in Europe’s roughly $13 trillion government bond market, up from about 30% in 2020, according to European Central Bank estimates. The International Monetary Fund has reported that hedge fund exposure to sovereign debt has more than doubled since 2022.

“The hedge fund community has ballooned,” said Lauréline Renaud-Chatelain, fixed-income strategy lead at Pictet Wealth Management. She linked the industry’s larger presence to greater volatility and said it could help explain the severity of the French sell-off despite the absence of a clear trigger.

The IMF has warned that large, leveraged and crowded hedge fund positions can increase price dislocations and pressure liquidity during market stress. Cash-futures basis trades and leveraged carry trades are sensitive to changes in bond prices and volatility. A sudden market shift can force several funds to close similar positions at the same time.

Bruno Schneller, managing partner at Erlen Capital Management, described rapid deleveraging as a potential source of self-reinforcing market moves. He cautioned against attributing the recent volatility solely to hedge funds.

Hedge funds have become more prominent partly because traditional buyers of government debt, including central banks, pension funds and banks, have reduced their activity. Their retreat has left hedge funds as a larger source of trading liquidity in sovereign bond markets.

Jiri Krol, global head of government affairs at the Alternative Investment Management Association, defended the industry and warned against broad conclusions based on limited evidence. Marion Le Morhedec, chief investment officer for fixed income at Fidelity International, noted that crowded positions and leverage could cause liquidity to disappear quickly if funds exited similar trades at the same time.

Regulators are focusing on repurchase agreement, or repo, markets, where hedge funds borrow money using government bonds as collateral. Bank of France data shows that French government debt accounts for about €100 billion of the €250 billion in eurozone sovereign bonds pledged as collateral in repo markets.

In the United Kingdom, the Bank of England estimates that hedge funds account for £85 billion of the £200 billion in net borrowing in gilt repo markets. JPMorgan Chief Financial Officer Jeremy Barnum described hedge fund leverage as a longstanding source of systemic risk.

Fund managers reported that the latest volatility had not materially disrupted their strategies. Some investors used the decline in French bond prices to increase their holdings. Michela Bariletti, chief credit officer at Standard Life, reported that the firm had selectively added French government debt after valuations became more attractive relative to the country’s credit risk.