U.S. BOND MARKET
We have all observed that significant developments are currently unfolding in the U.S. bond market.
The bond market continues to reflect uncertainty stemming from trade tensions, economic policy shifts, and rising debt concerns. Analysts suggest monitoring Federal Reserve actions and broader economic developments closely as these factors will likely influence yields further in the coming weeks.
In our view, several significant events are occurring simultaneously in the U.S. bond market.
Foreign investors, who hold U.S. securities, are reducing their positions by selling off their holdings.
Hedge funds have been compelled to unwind their positions, particularly in two key strategies they typically profit from: basis trades and swap trades.
Corporate borrowers with higher risk profiles are struggling to secure funding.
In this article, we examine these three factors and provide a detailed explanation of each.
FOREIGN INVESTORS
Foreign creditors like China and Japan, holding significant amounts of U.S. Treasury securities, are closely watched amid fears of reduced appetite for American debt.
Breakdown of U.S. Treasury Holders
Domestic Holders
U.S. Investors and Other Domestic Entities: Approximately 54.7% of total U.S. debt.
Federal Reserve System: Holds about 13% of total U.S. debt.
Social Security and Other U.S. Government Agencies: Account for roughly 6.7%.
Foreign Holders
Foreign entities collectively hold around 25% of U.S. Treasury debt, with the following key contributors:
Japan: 3.1%
China: 2.2%
United Kingdom: 2.2%
Luxembourg, Cayman Islands, and Canada: Each around 1%.
Other countries, including Belgium, Ireland, France, and Switzerland, hold smaller percentages.
Total Foreign Ownership
Foreign private investors and governments combined own approximately 25% of total U.S. debt.
This distribution highlights the significant role of both domestic and foreign stakeholders in the U.S. Treasury market, with Japan and China being the largest foreign holders.
Rising concerns about U.S. debt levels and selling by hedge funds have contributed to the sell-off. Additionally, fears of margin calls and liquidity demands are exacerbating market tensions.
HEDGE FUNDS
A basis trade is a financial strategy commonly employed by hedge funds to profit from price discrepancies between related financial instruments, typically involving Treasury securities and their futures contracts.
Hedge funds purchase Treasury securities (cash market) while simultaneously selling Treasury futures contracts.
The trade profits from the spread between the cash price and futures price, assuming they will converge as the futures contract approaches maturity.
Basis trades are highly leveraged, often using 20x to 50x the initial investment through the repo market, where Treasuries serve as collateral.
Basis trades can also involve swaps markets, exploiting spreads between rates like SOFR and Treasury yields.
What is a swap trade?
A swap trade is a derivative contract where two parties exchange cash flows or liabilities based on financial instruments.
In both basis and swap trades, a significant amount of leverage is utilized, as the purchase of cash Treasury bonds is financed through the repo market. A swap spread occurs as the difference between the fixed rate of an interest rate swap (swap rate) and the yield on a government bond with the same maturity, such as a U.S. Treasury security.
If Treasury prices drop, collateral values decrease, triggering margin calls. Hedge funds may be forced to liquidate positions, exacerbating market stress.
Several hedge funds were hit by margin calls given turbulent markets.
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