The sell-off of Russian debt related to Russian President Vladimir Putin’s campaign against Ukraine and related sanctions have created a window for a new kind of arbitrage that some in the financial world are devouring because they see it as easy money.
The idea behind this is what is known as negative basis trading, or buying dirt cheap Russian government or corporate bonds along with credit default swaps, which act as insurance against the potential default of a borrower.
Data from website MarketAxess shows that Russian government bonds traded at $7 billion between February 24 and April 7, up from $5 billion over the same period in 2021 – a 35% increase .
Russian bonds are trading wildly, said Philip M. Nichols, an expert on Russia and corporate social responsibility and a professor at the University of Pennsylvania’s Wharton School. “There are a lot of speculators buying up these bonds that have been severely downgraded and are about to go bad,” he said.
Nichols says he’s constantly getting calls from analysts interested in whether the potential trade makes sense. “The spread of Russia’s sovereign debt is amazing at the moment,” he said. “They’re making an unusual amount of money for volume.”
The cost of insuring Russian debt rose to 4,300 basis points on April 5 from 2,800 a day earlier.
At the same time, bond yields fell sharply — with bonds maturing in 2028 trading at just $0.34 to the dollar. That means it could cost just over $4 million to insure $10 million worth of Russian securities, The Economist reported. Hedge funds such as Aurelius Capital Management, GoldenTree Asset Management and Silver Point Capital have increased their exposure to Russian markets, mainly by buying corporate bonds, the Financial Times reported in late March. US financial institutions like JPMorgan Chase and Goldman Sachs are facilitating this trade by connecting clients looking to exit their positions with hedge funds that have higher risk appetites and fewer moral qualms about buying Russian debt.
“This is Wall Street,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “It doesn’t surprise me that they saw some kind of loophole that they could exploit to make money.”
JPMorgan officials say they act as middlemen, simply trying to help customers. “As a market maker, we have helped our clients to reduce their risks and manage their exposures in Russia on the secondary markets. None of the trades violate sanctions or benefit Russia,” a spokesman said.
If clients wanted to quickly reduce their exposure to Russia, they could turn to Russian oligarchs who would be keen to buy back government bonds, said Robert Tipp, chief investment strategist and head of global bonds at PGIM Fixed Income. Selling Russian debt to US hedge funds keeps all accrued interest out of Russian hands.
The trade is legal and lucrative, Nichols said, but highly speculative and volatile due to news of Russia’s invasion of Ukraine and further sanctions.
It also reveals an alarming disconnect between Wall Street and the actual state of the world economy: Typically, investors would base their valuation of Russian debt on whether or not it would be repaid, and the likelihood of it being repaid would depend on strength and durability the Russian economy.
But that doesn’t happen. New US Treasury Department sanctions on Tuesday that blocked Russia from accessing all the dollars it holds in American banks greatly increased the likelihood that Russia, with its debt and gross domestic product, the main measure of a country’s economic strength, was in default device fall.
The US Congress this week voted to strip Russia’s trade status from the most favored nation, a major economic downgrade that would pave the way for deeper sanctions and import controls on products essential to Russia, such as chemicals and steel.
Stripping that status, Nichols said, would disrupt Russia’s integration into the world economy. If Wall Street were connected to the real world, he added, they wouldn’t want to get anywhere near Russian debt.
“Russian debt is the domain of high-risk takers,” Nichols said, “and institutions should probably stay away.”