Japanese Bonds: When a Curve Steepener Loses $800m

by: Felix Salmon

In exceptional times such as these, I can understand how highly leveraged credit funds with a large risk appetite could end up losing a lot of money. But this is ridiculous:

A $3bn London hedge fund lost more than a quarter of its value on Monday as it became the biggest victim of the unwinding of a popular Japanese government bond trade that hit many rivals this week.
Endeavour Capital, run by former Salomon Smith Barney fixed-income traders, told investors it fell 27 per cent as a highly leveraged bet on the spread between short- and long-dated JGBs was hit by contagion from the US financial crisis and domestic worries.

I know that hedge funds are getting bigger these days, but $3 billion is still very big. And 27% of $3 billion - $810 million - is a hell of a lot of money by anyone's standards. So how did Endeavour endeavour to lose such an enormous sum? By putting on a curve steepener in Japan.

Hedge funds scrambled to unwind the so-called "box trade" - betting that 20-year bond and swap spreads would widen as seven-year spreads narrowed - early on Monday when the market moved sharply against them.

Why would anybody ever invest in a hedge fund when these things happen with alarming regularity? There was clearly something awry with Endeavour's risk controls, and equally clearly it would have been all but impossible for Endeavour's investors to know that ex ante. When it's impossible to know how strong your fund's risk controls are, then why invest in such a fund at all?

Update: Alea, in the comments, points out that the Japanese yield curve is incredibly steep right now. The spread between 7-year and 20-year rates is 129bp, which is enormous by Japanese standards. So prolly Endeavour was betting on the curve getting flatter, not steeper.