LONDON Hedge funds are piling into bets against the bonds of core euro zone countries like Germany and France, signaling 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 elsewhere deepens.
"There's definitely a feeling the market is getting shorter (i.e. 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 minimizing the importance of the European problem during most of Q1. There's a bit of a herding effect."
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 manager.
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 month.
"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 will rise.
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."
($1 = 0.7948 euros)
(Additional reporting by Tommy Wilkes; Editing by Sinead Cruise and Mark Potter)