Hedge funds to reap rewards on Cyprus default bet

Wed Mar 20, 2013 8:07am EDT

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* Cyprus sovereign bond signals default a remote outcome

* Depositor tax seen as the only option

* Politics takes precedence as crisis deepens

By Natalie Harrison and John Geddie

LONDON, March 20 (IFR) - The market price of a Cypriot sovereign bond due to mature in just over two months suggests a gamble by hedge funds that the country will avoid a default will pay off.

The EUR1.4bn 3.75% bond, due to be redeemed on June 3, is bid at 83% of its face value, signalling that the market expects creditors will be paid in full even though a EUR10bn bailout hangs in the balance.

The country's parliament on Tuesday voted unanimously against the controversial plan to make domestic depositors foot part of the bill for the island's debt woes, but market participants say an unprecedented levy on depositors to raise EUR5.8bn will be passed in one way or another.

Cyprus must raise that cash in order to secure the bailout money.

According to market sources, around half of the June 2013 bond is owned by hedge funds, but while its price has fallen by around seven points this week, a restructuring of Cyprus' EUR4bn sovereign debt is not on the table.

"There is a calculated gamble here that the contagion from deposit holders is less important than the contagion you would see if the Troika forced PSI in a second European country," said a portfolio manager at a large European fixed income fund.

Others agreed and suggested that a true default was also an unpalatable option.

"If Cyprus defaults, it is in Argentina territory, and would be locked out of the capital markets for 10 years," said one banker.

A significant amount of Cypriot bonds are governed by international law, which would make a restructuring like the EUR200bn Greek PSI extremely difficult.

Hitting EUR1.7bn of senior bank debt - which would have been an unprecedented move - was also deemed to have carried greater contagion risks.

Therefore, Cyprus has little option other than to hit depositors.

"There simply wasn't enough debt to haircut sovereign or senior bank bonds to make the numbers work," said Sohail Malik, manager at ECM Asset Management's special situations hedge fund.

"Another eurozone PSI and accelerating senior [bank debt] bail-ins by two years carried major contagion risks for the Troika," said Malik.

RUSSIAN GAMBIT

Cyprus is now expected to recast its rescue plan by reducing the burden on domestic savers and making rich Russian investors with deposits in excess of EUR100,000 suffer the bulk of losses instead.

That was the original plan back in December, before a decision to bring deposits below that threshold - which should have been protected anyway - into the firing line as well, banking sources said.

Imposing losses on depositors was the easiest way to get international investors involved, analysts and bankers said, and there is certainly a political motive at play.

Germany, Finland and the Netherlands - several market sources said - used this to attack the tax haven, which experts say Cyprus has become.

"There's no way out for Cyprus. Its whole business model is over because no one is going to risk putting their cash there now," said the banker.

EU policymakers insisted said that the Greek PSI was a one-off, and are stressing the same with Cyprus, arguing that the country's problems are unique because the country's banks and sovereign are so closely entwined.

Assets held by Cypriot banks account for around seven times the country's GDP, and they are also among the biggest holders of government debt, yet another reason why sovereign restructuring is not considered a realistic option.

"That would be robbing Peter to pay Paul," the banker said. (Reporting by Natalie Harrison and John Geddie; editing by Alex Chambers, Julian Baker)

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