Hedge fund troubles stir up bond markets

News Analysis: Issues worth pounds 7bn have surprised dealers

THE VOLATILITY in the normally placid sterling bond market over the past two weeks has been the most dramatic ever seen by traders.

The cause is the unwinding by Long-Term Capital Management, the US hedge fund, and other hedge funds of very large positions in the UK interest- rate swaps market.

The close, complex relationship between the swaps market and more traditional interest rate-linked instruments, such as UK government and quasi-government bonds, has led to a sudden flurry of new issues of sterling-denominated bonds by Triple A-rated institutions - so-called sovereign supranationals such as the World Bank and the European Investment Bank.

Eurosterling bonds worth more than pounds 7bn have been issued by these institutions in the past few weeks - a staggering amount in a market where new issuance in normal times runs at pounds 25bn to pounds 30bn a year.

Triple A is the highly coveted seal of approval granted by the powerful credit agencies such as Moody's and Standard & Poor's, as near as you can get to a cast-iron guarantee that, barring a direct asteroid hit, the bonds will pay in full, on time.

The institutions are exploiting a window of opportunity which the hedge- fund activity has suddenly opened to tap investors for funds.

On the one hand, gilts yields have fallen from a high of 6.25 per cent at the start of the year for the 10-year gilt to a low of 4.58 per cent. On the other, the cost of fixed-rate swaps has fallen sharply. This means that cheap fixed-rate swaps can be used to fund a higher coupon or yield on these new Eurosterling bonds.

Because of the impact of hedge-fund selling, sovereign supranationals have been pricing bonds to pay yields 60 basis points (0.6 per cent) higher than the comparable gilts. In normal times supranationals would be paying 20 basis points over gilts. Not surprisingly, these bonds are being snapped up by sterling investors desperate for an alternative to gilts, which at today's rock-bottom levels offer lousy value.

Market watchers say this is a window of opportunity which will close once the unwinding of the hedge funds' positions is completed. Most in the market reckon that will take four or five months at least, others say as much as nine months.

However, there is no evidence of private sector banks or companies being able to use the same route to access funds. The corporate bond market in Europe, as in the US, remains in effect shut.

Traumatised investors are still shying away from anything that smacks of risk. Since the Russian bond default, investors are more worried about losing their shirts than aiming for the moon. Anything other than Triple A, even double A, is not getting off the ground.

Sadly, apart from lowering funding costs for the big institutions, there will be little practical impact. No new bridges will be built, no more roads.

Bonds are nevertheless big business. About three-quarters of those working in the City deal in bonds. Foreign banks are pouring resources into London in anticipation of a huge new euro corporate bond market here in the next few years.

For many in the market, the fact that LTCM and other hedge funds had such large positions in the UK interest-rate market was a big surprise. It now appears that LTCM's John Meriwether was using the UK swaps market as another variation of the "convergence" play, betting that interest rates on UK gilts and swaps rates would fall rapidly to French and German levels once the UK committed itself to joining the euro.

But, in the sterling market as elsewhere, his gamble was blown by the sudden "flight to quality" that followed Russia's bond default. He reckoned that by going long on fixed-rate swaps and short on gilts, he was fully hedged and could close out the position at any time.

But the two markets diverged as gilt yields plummeted, and swaps became dramatically more expensive to reflect this new risk.

Since that initial hit the markets have recovered some ground, enabling the hedge funds to start unwinding their positions. Unfortunately, the UK swaps market is far shallower and less developed than the US. The unwinding, which involves selling swaps and buying gilts, is moving the market against the hedge funds again.

But, as the flurry of issuance shows, at least someone is winning business out of the turmoil.