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

Hedge funds are increasingly redirecting capital into swap spread arbitrage and other relative-value strategies, according to a report by Reuters, as higher Treasury yields, rising financing costs and regulatory changes reduce the attractiveness of the US Treasury cash-futures basis trade. The basis trade, which involves buying Treasuries with borrowed funds while selling Treasury futures to capture pricing differences, has plateaued after several years of rapid growth. Higher yields, increased financing costs and greater bank capacity to hold government bonds have narrowed arbitrage opportunities, prompting leveraged investors to look for returns elsewhere in the rates market.

Swap spread arbitrage, which exploits differences between Treasury yields and interest rate swap rates, has emerged as a key alternative. Analysts caution, however, that the strategy carries greater market risk than traditional basis trades. Research from the Dallas Federal Reserve indicates significantly higher dollar risk relative to the notional value of positions. Investors are also showing interest in arbitrage between newly issued and older Treasury securities, as well as trades exploiting yield differences between inflation-protected and conventional government bonds.

Federal Reserve research estimates that hedge funds held approximately $830bn in cash-futures basis positions as of September 2025, around 35% of their total long Treasury exposure. Over the same period, swap spread positions reached $305bn, or 13% of exposure, making them the second-largest Treasury-related position among hedge funds.

Despite the shift, the basis trade remains a dominant strategy for fixed income relative-value hedge funds. Analysts expect continued US government borrowing to sustain demand from leveraged Treasury investors, potentially supporting a recovery in basis trading as market conditions evolve.