Canada’s central bank is concerned about how the country is financing its debt. The Bank of Canada’s (BoC) latest Financial Stability Report flags the growing role of hedge funds in public bond auctions. They now represent over 40% of new Government of Canada (GoC) bond purchases, often financed with short-term loans secured by GoC bonds themselves. While this has boosted liquidity, the dependency and leverage are amplifying risks.
How Government Borrowing Impacts Your Borrowing Costs
Governments issue bonds to fund spending shortfalls, with interest rates set by supply and demand. When investor demand exceeds debt needs, the market is liquid and yields fall. After all, when everyone wants to lend you money, you pay the least.
When debt needs exceed available investor capital, borrowing costs rise. Bond issuers raise yields to attract investors, costing the government—and you—a lot more.
GoC bonds are the benchmark yield, setting the base cost for loans of similar terms. Since borrowers are competing for capital, they need to pay a higher yield—plus a premium for profit, risk, and spread. Higher 5-year GoC bond yields? That means that 5-year fixed-rate mortgage you’re eying is likely to climb too.
That’s the BoC’s central warning: if benchmark yields suddenly rise, it drags growth for the whole economy.
Hedge Funds Are Scooping Over 40% of Canada’s Bonds
Hedge fund bidding as a share of total bids at Government of Canada bond auctions, from previous BoC research. Last observation Dec 2024.
Source: Dept of Finance, Bank of Canada.
The BoC is increasingly worried about the GoC’s best bond customer—hedge funds. According to BoC research, hedge funds represented nearly zero GoC bond purchases 20 years ago. By 2015, they were buying roughly 10-15% of new issues. Today, they represent over 40%, according to the latest Financial Stability Report.
It’s worked out well for Canada so far. The inflow has boosted liquidity and kept borrowing costs down.
“This activity improves sovereign debt market liquidity and efficiency but also creates vulnerabilities,” warns the BoC.
The government wants cheap financing by issuing Canada’s safest asset. Hedge funds want the highest return. There’s an obvious mismatch in priorities—and it’s probably safe to assume the hedge funds did the math here.
Short-Term Gain For Long-Term Pain
Even a person with minor financial knowledge understands that investors aren’t paying hedge funds a 2 and 20 (2% for management, 20% of performance) to buy government bonds. They would have to use a lot of leverage, but who exactly is lending that leverage? Well, that’s a funny story…
“Hedge funds typically rely on leverage obtained from overnight or short-term funding,” explains the BoC.
You may have heard of the term repo, which is short-term, often overnight, collateralized loans. Institutions put up their assets, and agree to repurchase them at an agreed-upon rate. According to the BoC, hedge funds are increasingly tapping repos, often with GoC bonds, to finance the purchasing of—drumroll—GoC bonds.
The central bank notes that asset-manager repo borrowing has roughly doubled over five years to $300 billion. Over just the past 12 months, repo borrowing climbed 8% (+$22 billion), with hedge funds accounting for most of that growth. More than $130 billion in repo transactions take place in Canada every day, which sounds more like sharks circling than good news.
So far, it’s boosted the market. “But if hedge funds were forced to quickly unwind their positions—for example, due to a loss of access to repo funding—it could amplify price movements and lead to dysfunction in government bond markets,” warns the BoC.
Hedge funds represent a significant share of GoC bond buying, creating the appearance of liquidity. But they’re using short-term leverage to drum it up, which amplifies destabilization risks by intertwining short- and long-term exposures.
If repo funding tightens, collateral values fall, or volatility spikes, these buyers flip to forced sellers. That would flood the market with debt precisely when governments need to tap it most. It’s not just a problem for the funds—it sends contagion downstream to governments and borrowers.
Don’t cry for me Argentina…
— Canada
Forgive my ignorance if it’s clear to everyone else, but what does this mean?
This is exactly what go many South American economies into serious trouble with inflation. The Broad money supply is made up of mostly private bank created money, which is created to fund borrowing by corporations, consumers and govts. However, the govt through the bank of Canada also can create money directly, often via a float like a repo, or so called qualitative easing.
Hedge funds, which are bascially mutual funds without the rules, can borrow to buy, effectively creating leveraged investments. This is particularly effective with govt bonds, since the risk is considered to be close to zero. So often a hedge fund can borrow at a variable rate of at or below the overnight rate, and make money on the spread between the o/n rate and the yield of the bond.
This means that if I buy $1B in GoC bonds, paying 1.0%, while the bonds have a coupon rate of 2.75%, I would automatically make 1.75% on that $1B or $17,500,000 per year, with almost zero invested! All it requires is a good credit rating and some collateral.
The problem is this is a zero sum game. If the Broad money supply is growing faster than GDP (M3 v GDP) asz it has been in Canada since 2015 (10+:1) then this is the root cause of your inflation. Basically, the private banks are debasing the currency (deflating its value) by these actions.
So modern Monetary policy theory is based on the core concept that using the overnight rate to either encourage or discourage monetary expansion only works as long as raising rates actually reduces borrowing.
What’s happened, particularly in Canada, is that because demand for credit is almost infinitely inelastic, a 50, 75 or even 100bp change in rates is now having no effect on CPI.
Thge govt and bankers want you to believe its because of Trump, Putin, or whatever, but there is no mechanism that explains the systemic rise of prices other than systemic debasement by govt and private banks. As noted, the danger is that if these overnight rates change by 100+bp (1+%) this could cause a margin call for the hedge funds, who would then be forced to flood the market with GoC bonds, and probably create a no bid price issue. If the bonds have to be sold, and no one is buying, this creates a possible situation where either the BoC has to buy them up themselves, or the rate shoots up by 5-10%. Either way, this is bad for our economy.
Prof Krugman, in 2022 stated clearly the only solution to this quandry was to stop pretending that CPI and M3 are now not decoupled because of 25ys of MMP, and manage the growth of the M3 directly. However, banks dont like that, and Canada since 2015 is effectively a country run by bank CEOs, so we are in for a rough ride.
I think it means that hedge fund are betting on interest rates not increasing further or even declining. That way, their collateral (the GoC bonds) retains its value and they can continue to finance their purchase in the repo or overnight lending market. I can’t think of any other way the repo lending could be taken away from them. It seems unlikely the Government of Canada foresaw this type of activity when setting up the repo market. The unforeseen consequences are always the tricky bit, yes? I would appreciate seeing other peoples’ take on what is going on here.
Remember when the government said they were borrowing so you don’t have to? Who knew they meant “so you can’t?”
So, the real question is how 17y after the GFC Canada is here now. Hedge funds are using an arbitrage strategy to profit from margin rules. They’ve been doing it in the USA for at least 20ys. The so called Kerry trade, where you buy bonds on margin of 0-3%, paying an overnight variable rate while getting paid a coupon rate. This means with $3,000 you can buy between 100k and 2M in govt bonds. If the spread is 1.5%, you are making a lot of money with, in terms of investment risk, almost no risk.
Add to that in Canada private banks have massively expanded the M3 with mortgages based on made up appraisals, corporate lending, and massive govt deficits, and you have a perfect storm of debt. This is why 56% of the TSX 30 is Financial services stocks. That’s not a good thing, as banks are in no way productive, they are basically a private govt agency that profits on creating money to lend out.
This is exactly why Carney wrote off tens of Billions in HST for new builds in ON, since that was only ever going to increase prices post HST, and allow banks to keep pretending that their valuations were accurate.
For example, if we assume that prices in the GTA, lower BC, Ottawa are all 30-50% over FMV, that makes the position of the big 6 banks untenable. Even worse, since most of these mortgages are underwritten by the CHMC, it could almost double the national debt, since the CHMC has almost no reserves relative to their liabilities of 1.4Tr… So they didnt even borrow on your behalf, they promised to borrow to protect bank shareholders?
Free money, who wouldn’t? Tap repo for insane leverage, buy repo elible assets, repeat.
They all know the second Canada has a recession the only way it’ll be able to lower costs is by bidding up this debt, and they all cash out with massive short-term profits. There’s no downside for them, just amplified risk for the public.
Not exactly sure, but I think it’s a reference to how the Americans captured Argentina. They helped load them up on debt they knew it couldn’t pay, then forced a corporate loon into power (with a minority of seats somehow), who then looted the actual assets. We had the debt, now we have our Milei.
The world bank and the IMF were used to transition from direct colonialism and slavery, to financial colonialism and debt slavery. Consider the large hydroelectric project built in Ghana. It was built with borrowed money with a 5y term for interest rates, but a long term price for power to supply an alcan smelter built there. So within a few years, the cost of the debt was much much higher than the revenue from the electricity the dam generated. For Alcan, its a win win. They mine the bauxite in Jamaica, ship it to Ghana, process it there, and then send it to Europe or America. For the WB and IMF, they get a lot of interest. For the people of ghana, an unmitigated disaster.
This is why most of south America, who were the first wave of this stuff, along with the coups and cold war oppression, have since sought to end any debt relationship with the west, and sought out Chinese funding now. Africa and Asia is following them. Now maybe China is just as bad, but for now, the danger is once the USD is no longer the currency franca of trade, the USA, UK and CAD will lose most of their value. So not very good.
The chart showing bids instead of purchases is misleading. Detailing bond purchases at auction but not in the broader market is misleading.
Bad piece, bad journalism.
1. the Bank of Canada’s direct quote is “over 40% of purchases,” so their assertion is correct.
2. The Bank of Canada didn’t provide data for the purchases, but bids are effectively the same since it’s rare for allotments to be rejected. The auction is done after Finance Canada confirms market appetite, they don’t just get surprised and determine they’re just keep the auction going if there’s unfulfilled demand. lmao.
It’s only “bad journalism” if you’ve never worked in the bond market, and in which case it’s also “bad central banking” because they conflate the two often.
Oh snap. LOL. Add to that, if demand was so excessively high that the allotments are only being partially fulfilled, the yield would be a lot lower, but clearly not the case.
Willing to bet buddy’s a Realtor. It seems to be their approach that they once heard a finance term, so now they’ll go around telling people how things are done. They should really stick to their area of expertise, it’s not like any of us in finance would ever tell them how to take a headshot or put their face on the side of a bus.
Canada’s leveraging is following the example that led directly to 2009. From exaggerated housing appraisals to record deficits, the only thing currently supporting all this is Canada’s resource production.
The problem is, without investment, even that has decayed. The obvious solution is to unwind the housing mess, but so far Carney is not interested in that. So good luck!
No no no. This is because lazy unimaginative Canadian hedgies live on a “basis trades” where they buy in one market and sell in another for a guaranteed profit. All you need to do is identify the pricing discrepancy and you’ve made a profit… guaranteed. The problem is that the profits are very small, so you have to do massive trades. This is risky because price volatility in the underlying asset (GoC Bonds for example) is magnified by the size of the trades and can very quickly exceed the margin thresholds for the trades. Since the only asset the hedgies have handy and liquid are the GoC bonds themselves, they are forced to dump them to meet margin requirements. This in turn pushes the price of GoC bonds down, and interest rates up, creating a positive feedback loop. So yes… BoC and Finance are rightfully worried. But this is not unique to Canada. Every sovereign is worried about this now. The good news (sort of…) is that it’s not the large banks that finance hedge funds anymore. So if the whole basis trade/hedgies ecosystem goes sideways, it won’t bring down the banks…but it might crush the government…and every other entity that owes money based on government bond rates.