Hedge funds' big bet against Treasurys isn't what you think

Inflation, bond issuance and Fed tightening are spurring a Treasury derivative bonanza

- Eric Wallerstein

The basis trade, an innocuouslooking practice at the center of some of Wall Street's historic blowups, is back.

A popular way for hedge funds to profit from bond trading while minimizing their exposure to swings in the market, the basis trade exploits the price difference between Treasurys and Treasury futures. The resurgence is attracting fresh scrutiny from Wall Street because previous meltdowns have rattled global markets. Here's what traders say is going on now:

How the basis trade works

Hedge funds buy Treasurys, then bet against Treasury futures by selling contracts promising delivery of a bond on a specific date at a preset price. Instead of betting on the direction of bond markets, the trade seeks to take advantage of small differences in the securities' prices.

The trade works because large asset managers like pension funds often prefer buying Treasury futures that require less up-front cash than actual bonds. That tends to make the contracts slightly more expensive than the bonds, creating a window for speculators to take advantage. Futures prices typically converge toward bond prices as their settlement date approaches.

The differences are small, so hedge funds juice returns by borrowing from big banks in the overnight funding markets-often putting little, if any, cash up front. Leverage can reach extreme levels: Hedge funds had more than $550 billion of Treasury trades at the end of last year backed by just $10 billion of their own money, Fed research found.

That worries some on Wall Street. Unexpected shocks can force hedge funds to rapidly exit from their positions, sending shock waves through financial markets.

What's happening now