NEW YORK (Bloomberg) ? US President George W. Bush enters his second term awash in red ink. The nation confronts a series of annual budget deficits that may total $3.6 trillion by 2014, the Congressional Budget Office says.

As the government seeks to finance those gaps in the bond market, an often-unruly brand of investor has been buying US Treasuries as never before: hedge funds.

Loosely regulated investment vehicles for institutions and the wealthy, hedge funds piled into the $3.8 trillion Treasury market during 2004. One clue to their purchases: Investors based in Bermuda, the Bahamas, the Cayman Islands, the Netherlands Antilles and Panama ? tax-friendly jurisdictions where thousands of these funds are registered ? have amassed some of the world?s largest holdings of US government securities, Treasury Department figures show.

Caribbean Treasury investments soared 54 percent to $85.2 billion during the first ten months of 2004, seven times the 8.3 percent increase in all of 2003. The region is now the fourth- largest holder of US government debt, behind Japan, China and the UK.

The growing role of hedge funds in the Treasury market worries Richard Waugh, a managing director at Des Moines, Iowa- based Principal Global Investors, which manages $75 billion in fixed-income assets. That?s because hedge funds ? an $890 billion industry ? are typically active traders, not buy-and- hold investors. What they buy one moment they often sell the next.

?Hedge fund managers might change their minds about an asset class in a minute,? Waugh said. ?That?s one of the reasons why we?ve been avoiding the Treasury market.?

Some of Wall Street?s biggest bond traders ? the 22 primary dealers who trade directly with the Federal Reserve Bank of New York ? are keeping tabs on hedge funds, too. Amy Falls, global fixed income strategist at Morgan Stanley in New York, says the Treasury?s growing reliance on foreign bond investors and hedge funds poses dangers for bond investors.

?This raises the overall risk associated to Treasuries,? she said.

After $217 billion of net new capital flowed into hedge funds in the past three years, managers are offering investors less risk, more regulation and lower returns. So far, the funds continue to proliferate rapidly: 866 new ones opened during the first nine months of 2004, bringing the total to 7,156, according to Hedge Fund Research Inc. in Chicago. Since December 1997, the number of investment funds registered in the Cayman Islands has more than tripled to more than 4,000.

Treasury investors, for their part, are coming off their best year since 2002. US government notes returned 3.55 percent, including reinvested interest, in 2004 through December 10 compared with 2.26 percent for all of 2003, according to Merrill Lynch & Co.?s Treasury Master Index. Hedge funds that specialise in fixed-income trading have done well, too, posting an average return of five percent during the first ten months of 2004, according to a CSFB/Tremont hedge fund index.

Treasuries? run may be over now that the US Federal Reserve is raising interest rates to head off a new surge in inflation. The Fed raised its target for overnight loans between banks a quarter point to 2.25 percent on December 14, its fifth increase in 2004. The Fed is likely to keep raising rates in 2005, according to a Bloomberg News survey of the 22 primary dealers. As the Fed tightens credit, ten-year Treasury yields are likely to climb to 5.1 percent by the fourth quarter of 2005 from 4.15 percent on December 10, according to economists surveyed by Bloomberg News.

Bush is unlikely to rein in the budget deficit, which means the government will have to keep borrowing. Barclays Capital Inc. and Banc of America Securities LLC are among the largest bond-trading firms that expect the deficit to exceed $300 billion for at least two more years.

Whether debt yields rise in response to the deficit may depend on whether international investors ? including the Caribbean-registered hedge funds ? keep buying. Foreign investors and central banks own about half of all marketable Treasuries, up from 34 percent in mid-2001. Japan holds the most US government debt, with $715.2 billion as of October 31. It?s followed by China, with $174.6 billion, and the UK, with $140.9 billion.

?If it wasn?t for the large amount of purchases of Treasuries by foreign investors, including central banks and hedge funds, yields on government bonds would be much higher,? said Paul Kasriel, chief economist at Northern Trust Securities Inc. in Chicago.