Why hedge funds could be making a bond market shock more likely

An important development from the financial markets: Hedge funds' increased presence in global bond markets makes the likelihood of a broader market shock "greater than what it was," Bank of England deputy governor Sarah Breeden told CNBC Thursday. Breeden — the central bank's deputy governor for financial stability, and a member of its rates-setting Monetary Policy Committee — said the changing mix of bond market investors, and their increased use of leverage, raises the risk of localized market turbulence turning into broader financial stress. "One of the things that has become increasingly apparent over the last several years is that the investors in our core government bond markets globally have changed," Breeden told CNBC's Sri Jegarajah in an interview Thursday.

"It's not the real money investors, the insurance companies and pension funds, in the way it used to be. It's increasingly hedge funds, and those hedge funds are price-sensitive, leveraged, international. That, of course, means that the likelihood of a shock in one market transmitting to another is greater than what it was.

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" Breeden was speaking on the sidelines of the International Monetary Fund-World Bank annual meetings in Bangkok, Thailand. With gross assets now standing at about $13 trillion, hedge funds have become an increasingly important part of the global investor landscape, the IMF said on Tuesday. In its latest Global Financial Stability Report, published Tuesday, the IMF acknowledged hedge funds' role in supporting market liquidity and efficiency.

But it also warned that the hedge fund industry's use of leverage to boost returns, and its tendency to pursue crowded trades, could turbo-charge market stress in times of turmoil. That, in turn, could spill over into broader financial markets, and areas such as banks' prime brokerage businesses, according to the IMF. "The source of the shocks are bond markets, and the likelihood of a spillover is higher than it was," Breeden said.

Economists are analysing what the news means for the markets.