Hedge funds shift into riskier swap spread trades as Treasury basis strategy stalls

Hedge funds are increasingly allocating capital towards swap spread arbitrage and other relative-value strategies, as rising borrowing costs and regulatory changes diminish the attractiveness of the US Treasury basis trade, according to a Reuters report. This cash-futures basis trade, which capitalizes on the pricing discrepancies between US Treasuries purchased with borrowed funds and sold Treasury futures, has reached a plateau after years of exponential growth.

Factors contributing to this shift include elevated Treasury yields, increased financing costs, and a greater capacity among banks to hold government bonds, which have diminished arbitrage opportunities. Consequently, leveraged investors are turning to swap spread arbitrage to generate returns. This strategy, which profits from the difference between Treasury yields and interest rate swap rates, has become a key alternative to the traditional basis trades.

However, analysts caution that swap spread arbitrage poses greater market risk than conventional basis trades, with research from the Dallas Federal Reserve indicating a substantially higher dollar risk relative to the notional value of positions. As of September 2025, hedge funds had approximately $830 billion in cash-futures basis positions, comprising around 35% of their total long Treasury exposure, while swap spread positions totaled $305 billion, accounting for 13% of their overall Treasury-related investments, positioning them as the second-largest Treasury-related strategy among hedge funds.

Other strategies garnering interest include arbitrage between newly issued and older Treasury securities, as well as trades exploiting yield disparities between inflation-protected and conventional government bonds. Despite this strategic shift, the basis trade continues to be the dominant approach for fixed income relative-value hedge funds.

Analysts anticipate that sustained US government borrowing will maintain demand for leveraged Treasury investors, potentially paving the way for a recovery in basis trading as market conditions evolve.