For much of the past 18 months, investing in or against eurozone bonds has been a fool’s errand for the world’s $2tn hedge fund industry.

A regime of political vacillation and punishing volatility left few fund managers who sought to play the crisis-stricken market with anything to show for their efforts.

The average hedge fund lost 5.26 per cent last year, according to Hedge Fund Research: the industry’s second worst year on record.

Even George Soros was burned. His quantum fund lost 15 per cent in 2011 – having invested in, among other things, Italian government bonds – according to a person familiar with its performance.

But for some, European bond markets – sovereign and corporate – have recently generated big returns. And the signs are that they will continue to do so.

Across the eurozone, and beyond, hedge fund managers are now pointing to “significant” pricing anomalies on a scale not seen since 2008. A huge rally in credit has seen spreads tighten to pre-Lehman lows.

The reason for most hedge funds is clear. For all of its protestations to the contrary, the European Central Bank’s longer-term refinancing operation is having as profound an effect on markets as quantitative easing.

“The Fed and the Bank of England were early and significant proponents of QE; the ECB has only recently begun,” Michael Hintze, the founder of the $11bn credit hedge fund manager CQS wrote to clients earlier this year. “The thinly disguised QE move by the ECB – LTRO – still has further scope for expansion,” he said.

“The LTRO was a game changer,” says Suki Mann, a strategist at Société Générale. “We have seen the mother of all rallies in the first quarter – the third best quarter for credit ever.”

It was a question of buying risk, says Mr Mann – “the higher the beta the better.”

It is not merely the reflation trade – which is now showing signs of cooling – that hedge fund managers are interested in, though.

Rather, it is the unusual pricing that has occurred because of it.

“There is pretty strong evidence that the LTRO has warped pricing in some areas way beyond fundamentals,” says one hedge fund manager.

As eurosystem banks loaded up on Italian government debt following the LTRO, for example, strange things began to happen in Italian bond markets.

For example, on January 27th, inflation protected Italian government bonds maturing in 2021 were yielding 5.35 per cent, compared to 5.66 per cent for regular Italian government bonds of an almost exactly equal maturity.

An inflation swap could meanwhile be written for 2.31 per cent.

In other words, a hedge fund could have bought the inflation protected bond and written the swap for a fixed return of 7.66 per cent, and simultaneously gone short the regular Italian bond, completely hedging out credit risk, for a fixed cost of 5.66 per cent, locking in a gain of 2 per cent.

With leverage, such a trade – a classic example of relative value fixed income arbitrage – could have generated huge returns. And for some, it has.

Relative value arbitrageurs have enjoyed outsize returns ever since 2008 precisely because of the “uneconomic” distortions created in markets by central bank liquidity operations.

The Barnegat fund, a New Jersey-based hedge which launched after the collapse of LTCM – the world’s most notorious relative value arbitrageur – returned 132.68 per cent in 2009, thanks to “the largest arbitrage ever” – in the US bond market, caused by the Fed’s quantitative easing.

Barnegat founder Bob Treue says the LTRO is creating pricing anomalies that are almost as large.

“They are enormous,” says Mr Treue. “We normally don’t see these types of mispricing. The combination of government intervention – uneconomic actions – and very few competitors doing what we do means the returns are very good.”

Barnegat is up 18 per cent in the first quarter, having been among those to jump on the Italian bond trade.

Other relative value funds are performing strongly too.

Blackrock’s relative value fund hedge fund, Obsidian, was up 13.5 per cent as of the end of March for example.

Even in broader corporate credit arbitrage, meanwhile, the LTRO has flattened risk and is also throwing up big trading opportunities.

The CDX index – a basket of credit default swaps on investment grade corporates – is now trading at 85 basis points, having reached 81bp in March – a low not seen since before the collapse of Lehman Brothers.

Whether such low bond yields and credit spreads will widen or not soon is “the $64,000 question,” says SocGen’s Mr Mann.

So-called “decompression” trades, where managers expect certain credits to widen dramatically to others, are in particular vogue.

“Look at the pricing in credit between a Caixa and Deutsche Bank,” says one credit fund manager. “Something isn’t right there.”

Hedge fund managers are poring over a whole host of such potential trades which offer the kind of attractive risks most missed in 2011: assymetric ones.

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