Posthaste: This shift in Canada’s bond market is raising red flags

There’s been a shift in

Canada’s bond market

and it’s raising red flags with some observers.

As the Government of Canada bond market expands,

hedge funds

are grabbing a bigger share.

In recent auctions, these funds bought nearly half of the bonds available in some maturities, and took a 30 per cent share of secondary trading, said a report by Moody’s Analytics.

In 2010, hedge funds purchased less than 2 per cent of these bonds at auction.

“Hedge funds are now at the core of the Government of Canada bond market,” said Moody’s Analytics economist Charles Houston.

“This shift in market structure has important consequences for financial stability.”

One reason for the increase in hedge fund buying is that the Government of Canada has issued more bonds, with the value rising by more than 60 per cent since the start of the pandemic, says Moody’s.

Bank-owned dealers, who used to be the main buyers, have not been able to absorb the higher issuance because of their capital constraints and risk management policies.

“Hedge funds have stepped in to fill the gap,” he said.

Where the vulnerability lies is that hedge funds tend to use a strategy called cash-futures basis trade, which involves buying a bond in the cash market and selling a futures contract tied to that same bond.

These transactions are often financed through short-term borrowing in the repurchase (repo) market and their popularity is growing.

Volumes linked to this strategy hit $51 billion in April 2024, almost 10 per cent of the government of Canada bond market, according to the

Bank of Canada

.

When the bond market behaves predictably, the strategy works well, especially when trades are scaled up by borrowing. But when it doesn’t, things can go very bad, very quickly.

If bond volatility spikes, margin calls can increase and banks cut back on funding hedge funds’ positions, said Moody’s. Funds are then forced to quickly unwind their trades, swamping the market, and yields rise.

This vulnerability blew up in March 2020 in the

U.S. Treasuries market

when foreign central banks and bond funds dumped their Treasuries in a “dash for cash.”

The

Federal Reserve

was forced to step in,

buying more than US$1 trillion in Treasuries

in just one month.

More recently, it was seen in early April of this year, just days after

Donald Trump’s Liberation Day

roiled the stock market.

In a highly unusual situation, bond yields surged as stocks dropped, and the Treasuries basis trade was named as one of the big culprits.

The Bank of Canada identified cash-futures basis trade as a potential risk

in a 2024 report

that calculated that trading volumes in this strategy had more than doubled since 2016.

“While basis trades help to maintain an efficient government bond market, they can also amplify market stress,” said the report.

“Given the potential implications for financial stability, Bank of Canada staff will continue to monitor the size of the trade and the types of investors that participate in it.”

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Trump’s trade war has unleashed a tsunami of uncertainty on the world, as shown by this chart from National Bank of Canada tracking the volatility measures, VIX and Bloomberg Global Trade Policy Uncertainty Index, against the United States’ effective tariff rate.

“To be frank, the future of U.S. trade policy is as clear as mud,” said Avery Shenfeld, chief economist at CIBC Capital Markets.

However, “amidst all the noise, there’s been one point of consistency: no country is getting a “get out of tariffs free” card from the U.S.”

• U.S. trade issues will be in focus this week after U.S. President Trump threatened to impose a 35 per cent tariff on Canadian goods last week. Canada and the U.S. are working toward a trade agreement by an Aug. 1 deadline.
• Today’s Data: Canada wholesale trade for May
• Earnings: PrairieSky Royalty Ltd., Fastenal Co.

• Trump’s new tariff threat hikes uncertainty for Canadian businesses
  
• Are Canadian home prices about to roll over? Don’t bet the house on it
• Why was Jersey Milk cut from Canada and could other chocolate makers follow?

Once the black sheep of personal finance, reverse mortgages are now lower cost than in the old days, and far more mainstream. In fact, a 2023 Deloitte study found that 17 per cent of soon-to-retire homeowners were ready to tap their home equity to bridge a savings shortfall. Find out what you need to know about reverse mortgages and the best rates,

updated daily here.

Send us your summer job search stories

Recently, we published a feature on the

death of the summer job

as student unemployment reaches crisis levels. We want to hear directly from Canadians aged 15-24 about their summer job search.

Send us your story, in 50-100 words, and we’ll publish the best submissions in an upcoming edition of the Financial Post.

You can submit your story by email to

fp_economy@postmedia.com

under the subject heading “Summer job stories.” Please include your name, your age, the city and province where you reside, and a phone number to reach you.

McLister on mortgages

Want to learn more about mortgages? Mortgage strategist Robert McLister’s

Financial Post column

can help navigate the complex sector, from the latest trends to financing opportunities you won’t want to miss. Plus check his

mortgage rate page

for Canada’s lowest national mortgage rates, updated daily.

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Today’s Posthaste was written by Pamela Heaven with additional reporting from Financial Post staff, The Canadian Press and Bloomberg.

Have a story idea, pitch, embargoed report, or a suggestion for this newsletter? Email us at 

posthaste@postmedia.com

.

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