* Fears rise that core euro zone could get dragged into
* Managers believe safe-haven bets have gone too far
* Managers shorting France, Austria, Belgium, Germany
* Wary of liquidity drying up in peripheral markets
By Laurence Fletcher
LONDON, May 29 Hedge funds are piling into bets
against the bonds of core euro zone countries like Germany and
France, signalling a growing fear that nations once considered
safe havens could be dragged down by the crisis in peripheral
states like Greece and Spain.
After a buoyant first quarter for markets, when fears over
the euro zone debt crisis receded thanks to a 1-trillion-euro
($1.3 trillion) cash boost from the European Central Bank, hedge
funds have been quick to make sure they don't miss out as
concerns over the future of the single currency resurface.
Rather than bet on the likes of Greece and Spain, whose
problems are now well documented, funds are shorting the bonds
of core countries as a so-called 'tail hedge' - the purchase of
protection against extreme events such as the launch of
eurobonds, which would drive up the cost of borrowing for
Germany, or even a break up of the currency bloc.
While such bets have so far failed to pay off - rising
French bond prices drove yields to their lowest since September
2010 on Friday - hedge funds are targeting core countries
because liquidity is better than in peripheral markets and they
feel their safe-haven status has been exaggerated as the crisis
"There's definitely a feeling the market is getting shorter
(ie there are more short positions)," said one fund of funds
manager who asked not to be named.
"There are new entrants in the bearish trade, some U.S.
groups are trying to catch up after minimising the importance of
the European problem during most of Q1. There's a bit of a
Shorting means borrowing a security in anticipation the
price will fall, allowing the seller to make a profit by buying
it back more cheaply in future.
Yields on 10-year bonds of several core countries have
slumped this year, as investors hunt for alternatives to
Germany, whose safe-haven appeal allowed it to sell 4.56 billion
euros of bonds with a zero coupon last week.
Austrian 10-year bond yields have fallen to
less than 2.3 percent from more than 3.6 percent in January,
while French bond yields have dropped from more than 3.3 percent
to below 2.5 percent.
The sky-high demand for its bonds also looks to have
persuaded some funds to short Germany, said the fund of funds
Billionaire manager John Paulson is among those to be
shorting European sovereign bonds while he has also bought
credit default swaps - insurance designed to pay out in the
event of default - on European debt, he told investors last
"Everyone is one-way on that trade. Being long Germany is so
crowded that if there's a technical reversal you may have late
entrants running for the hills."
Meanwhile, managers are wary of shorting bonds of peripheral
countries, even though Italian yields have risen
since March and Spanish yields have also climbed
sharply, nearing the 7 percent danger level on Monday.
Some are cautious after seeing bid-offer spreads on certain
Greek bond issues widen sharply last year and after liquidity
dried up during the first stage of the credit crisis in 2008.
"Absolutely, no question ... a lot of funds are active in
sovereign bonds," said one prime broking executive.
"(But) if funds thought they wanted to be short peripheral
bonds then they will have to consider how much borrow liquidity
there is in some names. Maybe they're short core countries, not
because they expect them to default but because in certain
circumstances it could provide a tail hedge."
The fee to borrow French government bonds has risen to 19.9
basis points on Thursday from 18.6 basis points two months ago,
according to research group Data Explorers, while the fee on
Austrian bonds is up to 15.1 percent from 14 in February,
although the cost to borrow Belgian bonds has fallen since the
start of the year.
A Data Explorers spokesman said borrowing of government
bonds can be motivated either by short-selling or a desire by
banks to boost their capital ratios.
Funds are particularly keen on relative value trades -
betting a seemingly overpriced bond will fall while a cheap one
A second prime broker said some of the most popular trades
at the moment were shorting Spain and going long Italy, or vice
versa, although most were bearish on Spain, with shorts focusing
on the 5 to 10-year maturity range.
"We are seeing positions turned over fairly rapidly to take
advantage of short-term moves and short-term momentum in one
market versus another."
Funds are also shorting government bonds or using credit
default swaps (CDS) as a way of protecting their existing
positions from further big moves in markets.
Graham Neilson, chief investment strategist at credit hedge
fund firm Cairn Capital, which has $20.3 billion in assets under
management and advice across its business, is using Spanish CDS
to hedge positions in Spanish corporate bonds when he thinks the
risks surrounding Spain are higher.
However, not everyone is keen on sovereign bond trades.
"Even if it would make sense to put on relative value trades
or short positions on European govies (government bonds), we are
quite reluctant to do it," said Philippe Gougenheim, who is set
to launch a global macro fund later this year.
"We still prefer shorting Euro Stoxx against S&P and
shorting the euro. Both trades have been working well and have
the potential to generate more profit, while not being submitted
to the same liquidity risk as positions on govies."