LONDON (Reuters) - Some hedge funds who shunned or bet against European government bonds only three months ago are buying again as a sharp rise in yields offers them returns after a lacklustre 2016 for the industry.
Most hedge funds spent last year aggressively "short" on government bonds, but portfolio managers at individual funds and investment companies that invest in hedge funds - so-called funds-of-funds - told Reuters some are changing their view.
"We hear diverging opinions," said Pacome Breton, head of portfolio management at hedge fund allocator FQS Capital Partners. "Some after the rally up to December were cautious and taking profit for better entry points."
Other funds are buying on the expectation that faster inflation will keep yields at higher levels, he said.
Hedge funds are often first off the mark to identify trends, so concerted buying of government bonds may herald an increased allocation to government bonds by the wider investment industry.
On the flip side, they are also agile and could quickly exit their holdings if the market turns, for example in connection with political risks linked to Dutch, French, German and possibly Italian elections in 2017.
Last year, low yields kept many hedge funds away from government bonds, though some did invest in "ultra-long" bonds with a higher yield issued by euro zone countries.
Since then, yields have risen sharply across the board on signs of an improving global economy, expectations of reduced central bank monetary stimulus and with the election of Donald Trump as U.S. President raising hopes for fiscal stimulus and higher inflation in the world's richest country.
The yield on Germany's 10-year government bond, the region's benchmark, went from minus 0.16 percent in late September to a positive yield just shy of 0.50 percent in January.
At the same time, hedge fund demand for recent bond sales by European governments has been among the highest in years, according to the bankers who ran those transactions.
In January, Belgium, France, Spain, Italy and Portugal sold a total of 30 billion euros of bonds through syndicated bond sales. Hedge funds bought just over 2.5 billion euros of that.
Bankers who managed some of those syndications said demand from the funds was several billions higher. However, the governments preferred to sell to more long-term investors such as central banks and fund managers, the bankers said.
Demand was particularly strong at Italy's recent 6 billion euro syndicated bond sale, where over 1 billion euros, or 17.3 percent, was bought by hedge funds -- the highest percentage taken up by that class of investor in an Italian fixed-rate bond sale in at least five years.
Investors pulled over $100 billion from hedge funds in 2016 amid lacklustre performance, according to an eVestment report.
It was a difficult year for most investors with macro managers, who typically invest in bonds as well as currencies, racking up losses in seven out of 12 months, though still ending the year up a modest 1.49 percent, showed data from industry tracker Hedge Fund Research.
The hedge funds at the vanguard of buying government bonds this year are credit-based specialists and macro funds, which express a view on the macroeconomic situation, usually through bonds and currencies.
"We think the pendulum now swings the other way ... and hedge funds and other government bond investors are interested in going long bonds now," said Louis Gargour, chief investment officer at London-based LNG Capital.
"We went long after Trump became president, combined with better than expected data out of Germany and the UK in December and in January," he said.
Euro zone inflation rose to its highest level in the month of January, up 1.8 percent year-on-year. The highest since Feb 2013 and close to the European Central Bank's target of close to 2 percent.
Not all hedge funds are sold on government bonds.
"We don’t want to buy anything," said Alberto Gallo, head of macro strategies at Algebris. "We are short and we think that France 10-year will go to 1.5 percent, Italy 10-year will go wider to at least 2.5 percent, Bund 10-year to 0.6- 0.7 percent."
Said Haidar, founder and CIO at Haidar Capital Management, said government bond sales via syndication may offer short-term tactical opportunities to buy bonds.
New York-based Haidar, which managed $308 million in assets as of Nov. 30, according to its website, bought into France's inaugural Green bond and Italy's 15-year and Spain's 10-year.
"We think this steepening in European bonds is going to continue because people are going to anticipate the end of quantitative easing programmes," said Haidar.
Editing by Tom Heneghan