New Big Player in Treasury Market

September 9th, 2015 by

A great deal of attention has been paid to the U.S. bond market as we approach the first rate hike from the Federal Reserve—whenever that comes to pass.

The market’s perception of the relative safety of Treasurys has been reflected in the periodic jumps in bond purchases over the last year of volatility on the markets: whenever things get particularly bad, like with the Greek crisis, investors who feel vulnerable to the upheaval pile into the Treasurys market.

chasing yields

Now, with bond yields easing upward as traders shift gears and begin positioning themselves ahead of the impending Fed rate hike that many observers still expect at the September meeting of the FOMC, there are fewer buyers of U.S. debt while the interest rate outlook remains unclear. Moreover, China—typically the leading purchaser of our government bonds—has been a net seller of Treasurys over the last few months as mainland investors look to cover their losses in equities while the People’s Bank of China sells off its U.S. bonds to reconfigure its balance sheet and support the yuan.

Who’s Buying Treasurys?

One heretofore unknown hedge fund, Element Capital, has emerged as an aggressive buyer of Treasurys, snatching up an estimated 10% of all debt offerings by the U.S. government over the 10-month period between November and August. There are rules in place limiting any single buyer to no more than 35% of the debt offered at any given Treasury auction.

treasury_bondThe overarching problem is that the Treasury Department generally feels most comfortable with long-term bondholders, not investment funds that have trading strategies in mind. Such strategies have become fewer and farther between in the bond market since the financial crisis, according to the Wall Street Journal. The riskiness of these moves aside, the real story is what to make of Element’s rationale for the strategy, which has remained quietly under wraps.

Who is Element Capital?

Run by a Yale alumnus named Jeffrey Talpins, Element is a macro fund—a hedge fund that focuses primarily on global equity, bond, and currency markets. This type of investment fund attempts to capitalize on macroeconomic trends which are in some ways more predictable than trading strategies that employ a more narrow focus. Nonetheless, it is a riskier endeavor than all but the biggest investors are willing to swallow: the minimum contribution for an Element investor is $50 million, although the fund is not currently accepting new investment.

As of August of last year, the fund managed $4.3 billion in assets. It’s been active since 1997, producing nearly 20% annualized returns (including an impressive 35% in 2008, when most comparable hedge funds were destroyed by the financial crisis). Thus far, Element Capital has added 18.5% year-to-date.

Shorting T-Notes

Element’s massive bond-purchasing strategy is one way of unwinding the fund’s short positions on Treasurys, which was working fairly nicely so far over 2015. Before yields briefly dipped below 2% in both August, they hadn’t fallen below that mark since sinking to about 1.80% in March and April as the Greek debt crisis hit a fever pitch.

high-interest-rates

The fact that Treasury yields have recovered (indicating weaker demand) speaks to traders and investors expectations that there is a good chance the Fed will raise rates in September. If one believes that interest rates are set to rise, it makes little sense to buy government debt at current rates. At 2.25% on Wednesday afternoon, 10-year Treasury yields were their highest in a month.

Throwing another wrench in the outlook for the bond markets is the seeming divergence between the Bank of England and the Federal Reserve. While many had expected the BoE to shadow the Fed in raising its rates, the dovish tenor of BoE Governor Carney has led many to believe that the Fed will stand alone in lifting rates from their near-zero levels if it acts this month.