While equity markets tend to capture the headlines, it is often the bond market that sets the tone for everything else. Once in a while, something meaningful turns up in a place most people would not think to look, and I have found that more often than not it begins in the bond market.
For example, I recently discovered that hedge funds were the major buyers of newly issued United States Treasury debt and it got me wondering if this is also happening in Canada, who these hedge funds were, why they were doing so, are there any auxiliary effects and what would be the consequences if they stopped?
This brought me to Bank of Canada’s 2025 Financial Stability Report thanks to a piece I came across in Better Dwelling that appeared to be going down the same rabbit hole. According to the BOC report, hedge funds are now buying a massive 40 to 50 per cent of newly issued Government of Canada bonds. That level of participation reflects a meaningful change in the composition of demand over the years, as it was only five to 10 per cent a decade or more ago.
The strategy itself isn’t that complicated. Capital is borrowed in short-term funding markets, often tied to overnight rates such as Canadian Overnight Repo Rate Average (CORRA), and deployed into longer-dated government bonds across the five-, ten- and sometimes thirty-year maturities. The return comes from the spread between those funding costs and bond yields, with leverage used to make what would otherwise be modest differences more meaningful. The trade can also produce significant gains when longer-term yields fall and the yield curve flattens.
Demand for government bonds therefore becomes directly tied to the shape of the yield curve. As long as the spread between short-term rates and longer-term yields remains sufficient and there is a continued expectation that longer-term rates will drop, the trade attracts capital, and a lot of it. This has supported strong auction demand and allowed a growing amount of government issuance to be absorbed without a significant increase in borrowing costs. The market appears very liquid and well supported, even as supply expands. This is good news for the Canadian federal government, which is running the largest deficits outside of the 2020 COVID-19 pandemic response.
However, this type of demand brings a completely different set of sensitivities and risks. Because participation is influenced by the relationship between funding costs and bond yields, when that relationship shifts, demand can change with it. Suddenly a government may find half of its buyers gone and then has to choose between cutting back spending or printing money.
The problem is that adjustment would not remain confined to just the government. Mortgage rates, corporate financing and other borrowing costs tend to move from that same base, also taking liquidity away from the economy and market.
The same dynamic is widely believed to exist in the United States, although the structure is a lot more complex and not as directly observable. This is because the Treasury market is significantly larger and more fragmented, and involves a broader mix of participants. Much of the activity takes place through repo markets, derivatives and other channels that are not as tied directly to public issuance data.
Interestingly, when looking at the relationship to broader equity markets, there is a pattern where equities tend to correct when these spreads narrow and strengthen when they widen. It suggests that keeping a close eye on these spreads may offer a useful way to gauge underlying liquidity conditions and, by extension, the general direction of markets.
Investors should be aware that the bond market warning signal many are missing is this heavy reliance on hedge fund demand. While it has helped keep borrowing costs low and markets liquid, a reversal could trigger significant turmoil across asset classes.
