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That's a risk investors should watchLast updated 1 hour ago You can save this article by registering for free here. Or sign-in if you have an account.While equity markets tend to capture the headlines, it is often the bond market that sets the tone for everything else. Photo by Panasevich/Getty ImagesOnce in a while, something meaningful turns up in a place most people would not think to look, and I have found that more often than not it begins in the bond market.Subscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman, and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.Subscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one account.Share your thoughts and join the conversation in the comments.Enjoy additional articles per month.Get email updates from your favourite authors.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one accountShare your thoughts and join the conversation in the commentsEnjoy additional articles per monthGet email updates from your favourite authorsSign In or Create an AccountorFor example, I recently discovered that hedge funds were the major buyers of newly issued United States Treasury debt and it got me wondering if this is also happening in Canada, who these hedge funds were, why they were doing so, are there any auxiliary effects and what would be the consequences if they stopped?This brought me to Bank of Canada’s 2025 Financial Stability Report thanks to a piece I came across in Better Dwelling that appeared to be going down the same rabbit hole. According to the BOC report, hedge funds are now buying a massive 40 to 50 per cent of newly issued Government of Canada bonds. That level of participation reflects a meaningful change in the composition of demand over the years, as it was only five to 10 per cent a decade or more ago.Canada's best source for investing news, analysis and insight.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Investor will soon be in your inbox.We encountered an issue signing you up. Please try againThe strategy itself isn’t that complicated. Capital is borrowed in short-term funding markets, often tied to overnight rates such as Canadian Overnight Repo Rate Average (CORRA), and deployed into longer-dated government bonds across the five-, ten- and sometimes thirty-year maturities. The return comes from the spread between those funding costs and bond yields, with leverage used to make what would otherwise be modest differences more meaningful. The trade can also produce significant gains when longer-term yields fall and the yield curve flattens.Demand for government bonds therefore becomes directly tied to the shape of the yield curve. As long as the spread between short-term rates and longer-term yields remains sufficient and there is a continued expectation that longer-term rates will drop, the trade attracts capital, and a lot of it. This has supported strong auction demand and allowed a growing amount of government issuance to be absorbed without a significant increase in borrowing costs. The market appears very liquid and well supported, even as supply expands. This is good news for the Canadian federal government, which is running the largest deficits outside of the 2020 COVID-19 pandemic response.However, this type of demand brings a completely different set of sensitivities and risks. Because participation is influenced by the relationship between funding costs and bond yields, when that relationship shifts, demand can change with it. Suddenly a government may find half of its buyers gone and then has to choose between cutting back spending or printing money.The problem is that adjustment would not remain confined to just the government. Mortgage rates, corporate financing and other borrowing costs tend to move from that same base, also taking liquidity away from the economy and market.The same dynamic is widely believed to exist in the United States, although the structure is a lot more complex and not as directly observable. This is because the Treasury market is significantly larger and more fragmented, and involves a broader mix of participants. Much of the activity takes place through repo markets, derivatives and other channels that are not as tied directly to public issuance data.Interestingly, when looking at the relationship to broader equity markets, there is a pattern where equities tend to correct when these spreads narrow and strengthen when they widen. It suggests that keeping a close eye on these spreads may offer a useful way to gauge underlying liquidity conditions and, by extension, the general direction of markets.In the end, the concern is not simply who is buying government debt but why they are buying it. I do worry that a growing share of sovereign issuance now depends on a large set of investors responding to pricing relationships rather than long-term ownership or fundamental conviction.While equity markets tend to capture the headlines, it is often the bond market that sets the tone for everything else. When it is functioning smoothly, liquidity moves freely and risk assets generally find support. As funding conditions begin to evolve, those changes tend to work their way through the system rather than remain contained in one corner.Therefore it is an area that warrants closer attention. Looking past the surface, asking a few additional questions and staying attuned to how capital is actually sourced and priced can offer a different vantage point on both risk and opportunity. That’s a spread worth spending some time on.Martin Pelletier, CFA, is the author of Investing Through the Storm and a senior portfolio manager at TriVest Wealth, a team that is part of Wellington-Altus Private Counsel Inc. TriVest provides discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus._____________________________________________________________If you like this story, sign up for the FP Investor Newsletter. Join the Conversation This website uses cookies to personalize your content (including ads), and allows us to analyze our traffic. Read more about cookies here. By continuing to use our site, you agree to our Terms of Use and Privacy Policy.