Hedge funds are scaling back their involvement in the US Treasury basis trade as weaker returns and changing demand for government bonds and futures reduce the attractiveness of one of the market’s best-known leveraged strategies, according to a report by Reuters.

Morgan Stanley estimates that capital deployed in leveraged basis positions has fallen by around 20% this year to approximately $1.2tn. The decline comes as expectations for US interest rates have risen in a relatively orderly fashion and trading conditions have become less conducive to generating the spreads on which the strategy depends.

The Treasury basis trade typically involves hedge funds buying Treasury securities while simultaneously shorting related futures contracts. Funds finance the cash-bond positions with short-term borrowing, seeking to capture the relatively small price discrepancy between the two instruments while using leverage to amplify returns.

The strategy has attracted scrutiny during periods of severe market stress because the substantial borrowing used by hedge funds can leave positions vulnerable to margin calls. Forced selling of Treasuries can then amplify market declines when liquidity deteriorates.

The current retreat, however, is being driven primarily by a less favourable opportunity set rather than a disorderly unwinding of positions.

Treasury prices have come under pressure this year as demand for both cash securities and futures has softened. At the same time, major securities dealers are holding larger Treasury inventories following a regulatory change, while government buybacks have supported prices for older, or off-the-run, securities. Those developments have reduced some of the potential price discrepancies that basis traders seek to exploit.

The strategy relies in part on demand from mutual funds and other asset managers seeking long-dated Treasury exposure to increase the duration, or sensitivity to interest-rate movements, of their portfolios.

Hedge funds can facilitate that demand by purchasing cash Treasuries and selling the corresponding futures contracts. The bonds can subsequently be delivered against the futures positions, with the cheapest eligible security typically used to settle the transaction.

Basis trading is active across the Treasury curve, with positions concentrated not only in the benchmark 10-year and longer maturities but also in the two-year and five-year sectors.

The reduction in activity so far has been most pronounced in futures linked to two- and five-year Treasuries, according to Morgan Stanley analysts. Those shorter maturities are particularly sensitive to changes in expectations for Federal Reserve policy and therefore can become less attractive for basis strategies when investors reduce their demand for long positions.