(Bloomberg) ? Bermuda-based Value Capital LP, a $570 million hedge fund backed by billionaire investor Warren Buffett, may report an annual loss for the first time in seven years after making a bad bet on US interest rates.

The miscalculation cost Buffett's Berkshire Hathaway Inc. $34 million before taxes in the first nine months of 2005, according to a November 4 filing with the US Securities and Exchange Commission. Omaha, Nebraska-based Berkshire Hathaway had $3.4 billion in net income over the same period.

Mark Byrne, who runs Value Capital, said he erred by anticipating that long-term borrowing costs would rise faster than short-term rates as the US economy strengthened. Instead, the gap between 2-year and ten-year bond yields, known as the yield curve, narrowed by more than 1 percentage point to the smallest since January 2001, as the Federal Reserve raised the overnight bank lending rate 12 times.

"I don't understand why the yield curve is so flat," said Byrne, whose fund is down about 5 percent this year. "We had bets in the direction of a steepening yield curve as the US recovered from its cycle and the Fed started to raise rates."

Byrne, 43, former head of fixed-income arbitrage at Credit Suisse First Boston, founded Hamilton, Bermuda-based Value Capital in 1998 to profit on price discrepancies between bonds sold by developing countries, including Brazil, Mexico and Egypt. Berkshire Hathaway, the publicly traded investment company that Buffett uses to buy stocks and companies, was Value Capital's sole outside investor from 1998 until last year.

Berkshire Hathaway invested about $430 million in the fund through the end of 2002 and recorded $173 million of profits, a March 2003 filing with the SEC shows. From 2000 to 2002, Byrne also ran Berkshire Hathaway's derivatives unit, General Re Financial Products.

Debbie Bosanek, Buffett's assistant, said Berkshire Hathaway doesn't comment on individual holdings.

Byrne wasn't the only money manager caught off guard as foreign demand for US Treasury bonds flattened the yield curve. The average so-called relative-value arbitrage hedge fund is down almost 1.7 percent this year, according to data compiled by Chicago-based Hedge Fund Research Inc.

"A lot of people who placed bets on the yield curve steepening did get hammered," said Duncan Hennes, chief executive officer of PFG Advisors, a Greenwich, Connecticut, hedge fund firm that specialises in fixed-income strategies.

This year's 65 percent increase in foreign holdings of Treasury bonds reduced price fluctuations, or volatility, in the bond market. Value Capital relies on volatility to make profitable trades. Byrne invests in government bonds, interest- rate derivatives and currencies.

"A huge excess of liquidity in the world has created a lot of buyers for bonds," Byrne said in an interview. "That could explain both the low volatility and the low level of long-term yields."

West End Capital Management Ltd., Byrne's fund-management company in Bermuda, opened Value Capital to outside investors in 2004, raising about $300 million. Berkshire Hathaway withdrew about $125 million from the fund in December, reducing its stake to 62 percent from 90 percent on June 30, 2004, according to an SEC filing in March.

Byrne said his fund has been profitable for the past six years and generated average annual returns of 7.5 percent for Berkshire Hathaway after fees and expenses.

Berkshire Hathaway shareholders asked Buffett, 75, about his investment in Value Capital at annual meetings during the past several years because it's unusual for him to entrust money with another fund manager, said Whitney Tilson, principal at New York-based T2 Partners Management LLC, which owns Berkshire Hathaway shares.

"To my knowledge, it's the only investment Berkshire Hathaway has in an outside money manager," Tilson said.

Byrne is the son of Jack Byrne, who became chief executive officer of Geico Corp. in 1976 and saved it from bankruptcy after Berkshire Hathaway invested in the auto insurer. Patrick Byrne, Mark Byrne's brother, worked from 1997 to 1999 as CEO of Fechheimer Brothers Co., a uniform maker owned by Berkshire Hathaway.

"We've made a lot of money with the Byrne family," Buffett told Berkshire Hathaway shareholders at the company's 2003 annual meeting, according to a transcript prepared by T2's Tilson. At the same meeting, Buffett said, "I've looked at Mark's portfolio and I like the positions."