Obscure Hedge Fund Buys Billions of Dollars of U.S. Treasurys
Element Capital has been biggest purchaser in several recent auctions
A little-known New York hedge fund run by a former Yale University math whiz has been buying tens of billions of dollars of U.S. Treasury debt at recent auctions, drawing attention from the Treasury Department and Wall Street.
Element Capital Management LLC, led by trader Jeffrey Talpins, has been the largest purchaser in dozens of government-bond auctions over the past 10 months, people familiar with the matter said. The buying is part of an apparent effort by the fund to use borrowed money to exploit small inefficiencies in the world’s most liquid securities market, a strategy that is delivering sizable profits, said people close to the matter.
Mr. Talpins is an intense and reserved trader formerly at Citigroup Inc. and Goldman Sachs Group Inc. He is known for a tenacious style that can grate on rivals and once tested the patience of former Federal Reserve Chairman Ben Bernanke.
Element has been the largest bidder in many of the 62 Treasury note and bond auctions between last November and July, these people said. At many recent auctions, some of which involved sales of more than $30 billion of debt, Element purchased about 10% of the issue, these people said. That is an unusually large figure, analysts said.
Element’s activity has raised questions because the cumulative purchases far exceed the hedge fund’s $6 billion in assets under management. Treasury officials, who frequently meet with large auction participants, have asked Element about its activity, said someone close to the matter.
“Their buying is eyebrow-raising,” said a trader who once worked for a firm that deals in government securities and witnessed Element’s bidding. These primary dealers often know the identity of other auction bidders. Element “never shared its strategy, but we often asked,” the trader said.
Treasury likes to know who is buying its bonds and why, partly because it prefers long-term holders such as pension funds, insurance companies and central banks. Treasury officials fear purchases by trading-oriented funds could result in sales that increase market swings and potentially drive up borrowing costs.
“If you’re issuing debt, your preference is those ‘sticky investors,’” said Scott Skyrm, a managing director at Wedbush Securities.
Element is a “macro” fund, or one that wagers on global macroeconomic trends in bond, stock and currency markets. The firm uses a “unique probabilistic approach,” according to a presentation the firm made last year at the University of Pennsylvania’s Wharton School.
Element had been shorting, or betting against, bonds in anticipation of higher interest rates but has been exiting from that wager, according to someone close to the matter. That is one reason the fund has been a big buyer of Treasurys lately.
But people who have worked with the firm or are close to Mr. Talpins said there is another reason: 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.
After the 2008 financial crisis, bank traders pulled back as regulators discouraged trading risks. Some hedge funds also began shying away from bond-auction strategies. Wall Street banks have significantly cut back their lending to hedge funds.
The pullback by rivals has left Element with a large presence in bond auctions to complement strategies such as in foreign-currency derivatives, people close to the matter said. In 2008, the firm gained 35%, these people say, even as financial markets crumbled. The next year, Element was up 79%. Last year it rose just 2.9%.
But it was up 18.5% through July of this year, an investor said, beating most hedge funds and overall markets. Some recent gains came from bullish wagers on the U.S. dollar, according to the person. The firm’s annualized average return has exceeded 20% since its launch, investors said.
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.
Mr. Talpins graduated in 1997 from Yale, where he was a research assistant for Robert Shiller, the Yale economist who later won a Nobel prize in economics. In a 1996 letter, Mr. Shiller wrote that in terms of overall performance, he “put Jeffrey first out of the 52 Yale undergraduates” who attended his course Economics 252, Finance, Theory and Application.
“I thought he was particularly bright,” recalls Prof. Shiller.
Founded in 2005 by Mr. Talpins, Element is closed to new investments. When open it has required a $50 million minimum investment, an unusually large sum in an industry where $1 million is more typical. Friends say Mr. Talpins has been spending more time on philanthropy lately. But sometimes he rubs people the wrong way.
A year or so ago, Mr. Talpins was among 20 investors invited by a Wall Street firm to a private meeting with Mr. Bernanke, after his departure from the Fed. Mr. Talpins peppered Mr. Bernanke with about 10 successive questions, according to several people in the room.
Mr. Talpins elicited some detailed answers, such as who is in the room during interest-rate discussions. But he also asked questions that exasperated some investors because they seemed irrelevant. Mr. Bernanke looked increasingly weary under Mr. Talpins’s barrage, one participant said.
“Jeff was persistent and it got a little uncomfortable,” said another participant. “It was like, ‘Dude, let it go.’”
A spokesman for Mr. Bernanke declined to comment. Someone close to Mr. Talpins said he was eager to learn about the Fed’s inner workings because of his focus on interest-rate moves.
Element’s purchases appear compliant with rules that limit one buyer to 35% of debt sold in any auction. The limit most famously came into play in the 1991 Salomon Brothers scandal.
“Consistent with our policy, Treasury does not comment on individual investors in Treasury auctions or conversations with market participants,” a Treasury representative said.