A Short Introduction to "Bond-Auction Strategies"

Element is among the last to embrace “bond-auction strategies,” trading maneuvers that have become less popular since the financial crisis. 

These trades aim to take advantage of the effects of supply and demand in the $12.8 trillion Treasury market. Demand for these bonds often fluctuates based on factors including investor perceptions of economic growth and market risk, while supply can be affected by regular auctions of different-maturity Treasury securities. A burst of new supply tends to slightly depress prices for short periods, sometimes for less than an hour. 

In the past, Wall Street dealers and hedge funds scored profits shorting “when-issued” bonds. These are contracts conferring the right to purchase Treasury securities when they are sold days later at auction. Then, these traders would buy bonds during Treasury auctions at the slightly lower prices and use these newly purchased bonds to close out their short sales. 

The difference between the higher price at which they sold the Treasurys and the lower price they paid at auction was their profit.
There are a number of variations to this strategy, traders said. The maneuver involves a bet against bonds, so traders usually purchased hedges such as Treasury futures or interest-rate swaps to protect against rising bond prices while the trade was under way, said Tom di Galoma, head of fixed-income and rates trading at ED&F Man. 

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There are dangers with the auction strategy. Once in a while, the prices of bonds being auctioned jump, rather than fall, for reasons such as bad economic news that prompts an investor flight to safety. Hedges sometimes don’t work out. And the strategy relies on inexpensive borrowing because each trade usually yields minimal profits. 

In the 1990s, hedge fund Long Term Capital Management used leverage to profit from small discrepancies in the Treasury market before a market reversal swamped the firm. LTCM used much more leverage than Element does.

Cui, Carolyn and Zuckerman, Gregory. "Obscure Funds Buys Billions in Treasurys" The Wall Street Journal., Wednesday, September 9, 2015, A1, Accessed on September 9, 2015, http://www.wsj.com/articles/an-obscure-hedge-fund-is-buying-tens-of-billions-of-dollars-of-u-s-treasurys-1441704601