Hedge Fund Is Gobbling up Treasuries

The WSJ has an interesting story on Element Capital. This is a hedge fund that’s been buying up U.S. Treasuries at a furious pace. Element is run by Jeffrey Talpins, “a former Yale University math whiz.”

Element had been shorting, or betting against, bonds in anticipation of higher interest rates but has been exiting from that wager, according to someone close to the matter. That is one reason the fund has been a big buyer of Treasurys lately.

But people who have worked with the firm or are close to Mr. Talpins said there is another reason: Element is among the last to embrace “bond-auction strategies,” trading maneuvers that have become less popular since the financial crisis.

These trades aim to take advantage of the effects of supply and demand in the $12.8 trillion Treasury market. Demand for these bonds often fluctuates based on factors including investor perceptions of economic growth and market risk, while supply can be affected by regular auctions of different-maturity Treasury securities. A burst of new supply tends to slightly depress prices for short periods, sometimes for less than an hour.

In the past, Wall Street dealers and hedge funds scored profits shorting “when-issued” bonds. These are contracts conferring the right to purchase Treasury securities when they are sold days later at auction. Then, these traders would buy bonds during Treasury auctions at the slightly lower prices and use these newly purchased bonds to close out their short sales.

The difference between the higher price at which they sold the Treasurys and the lower price they paid at auction was their profit.

There are a number of variations to this strategy, traders said. The maneuver involves a bet against bonds, so traders usually purchased hedges such as Treasury futures or interest-rate swaps to protect against rising bond prices while the trade was under way, said Tom di Galoma, head of fixed-income and rates trading at ED&F Man.

After the 2008 financial crisis, bank traders pulled back as regulators discouraged trading risks. Some hedge funds also began shying away from bond-auction strategies. Wall Street banks have significantly cut back their lending to hedge funds.

The pullback by rivals has left Element with a large presence in bond auctions to complement strategies such as in foreign-currency derivatives, people close to the matter said. In 2008, the firm gained 35%, these people say, even as financial markets crumbled. The next year, Element was up 79%. Last year it rose just 2.9%.

But it was up 18.5% through July of this year, an investor said, beating most hedge funds and overall markets. Some recent gains came from bullish wagers on the U.S. dollar, according to the person. The firm’s annualized average return has exceeded 20% since its launch, investors said.

There are dangers with the auction strategy. Once in a while, the prices of bonds being auctioned jump, rather than fall, for reasons such as bad economic news that prompts an investor flight to safety. Hedges sometimes don’t work out. And the strategy relies on inexpensive borrowing because each trade usually yields minimal profits.

In other words, there are no hacks in the market.

Posted by on September 8th, 2015 at 9:04 am


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