A person inside a financial maze made out of hedges.
iStock.com / Cafillu

Hedge funds typically supply liquidity to Canadian bond markets but in the Covid-19 crisis they joined the herd, exacerbating market stress, according to new research from the Bank of Canada.

Central bank researchers examined the role of hedge funds in government bond markets, finding that they’re usually on the opposite of the market from other traders — buying bonds when other traders are selling and selling when others are buying.

“Their transactions typically promote a two-sided [government] bond market, which can help dealers more easily find the bonds or cash needed to fulfill the transactions of their different clients,” a paper from the central bank said.

At the same time, hedge funds that are taking the opposite side of the market generally “earn higher returns than the average returns of [government] bonds,” it said. “This outperformance could be compensation for supporting market liquidity or could be related to other investment strategies.”

However, when market stress surged in March 2020 early in the Covid-19 pandemic, the researchers found that hedge funds sold bonds alongside other traders, amplifying the drop in market liquidity.

“Concerns around redemptions, increased margin calls or a desire to reduce leverage are all potential reasons for hedge funds’ sales of [government] bonds,” the paper said.

Regardless of the reasons, the researchers found that “hedge funds can at times contribute to one-sided markets and amplify declines in market liquidity.”

“These results help to advance [Bank of Canada] staff’s understanding of the asset management sector and of asset managers’ behaviour in periods of market turmoil,” it concluded.