Pimco bets on Russian debt recovery in CDS auction

7 min read
EMEA, Emerging Markets
Robert Hogg, Christopher Whittall

Pimco appeared to make a bet that Russian sovereign bond prices can continue to recover, when the investment giant placed a large order to buy Russian debt in an auction used to settle credit default swaps on the country, according to sources familiar with the matter.

In Monday's historic CDS auction, which many had feared may never take place because of US sanctions against Moscow, Goldman Sachs placed about US$1.3bn of orders to buy Russian bonds on behalf of sellers of Russia CDS protection. Banks act as brokers in CDS auctions to place buy and sell requests on behalf of clients, which are not named publicly, and also to enter orders for their own account if needed. That process allows firms to settle their derivatives contracts physically.

Filings show Pimco has been one of the most prominent sellers of Russia CDS protection and would therefore be eligible to buy large amounts of bonds in the auction to settle that exposure – and two sources confirmed the investment manager was heavily involved. Spokespeople at Pimco and Goldman Sachs declined to comment.

Experts said the high demand from sellers of CDS protection to take physical delivery of bonds to settle their CDS contracts – and effectively switch their Russia CDS exposure for Russian bond exposure – suggests that investors like Pimco may well see further upside in the value of these securities.

"It’s not surprising to see a bunch of CDS holders asking for physical settlement in the auction, because they may think that some day they’ll get a much higher recovery rate on the bonds," said John Williams, a partner at law firm Milbank.

"In a normal distressed event, there can be varying views on the underlying recovery value of the debt, but it’s more of a spectrum of outcomes. This is essentially bimodal: Russia has plenty of money and has wanted to pay bondholders, but Western sanctions have prevented them from doing so.”

Pimco's large buy order helped drive a further resurgence in the value of Russian sovereign bond prices, which had traded down to near zero earlier this year following Moscow's invasion of Ukraine. After taking into account offsetting requests to sell bonds in the auction, there was net demand of just over US$500m to buy Russian debt, which helped push the recovery rate for Russia CDS up to 56 cents.

That was several points higher than the level banks had indicated in the first round of the auction when asked to put a value on Russian bonds. It means CDS holders that cash settle will recoup 44 cents for every dollar of default protection they bought on Russian hard currency debt.

Welcome relief

Finance professionals welcomed the successful resolution of the Russia CDS auction following months of uncertainty in what has proven to be a fraught and complex process to settle these derivatives contracts. Russia CDS triggered in early June, after Moscow was judged to have missed some small interest payments to investors.

A US Treasury ban on US firms buying Russian bonds in secondary markets had threatened to derail the process entirely because the auction mechanism requires bank trading desks to be able to buy and sell Russian debt to establish a fair payout for CDS holders. In the end, the derivatives industry managed to secure a temporary carve-out from the sanctions that permitted trading of Russian bonds two business days before and eight business days after the auction.

The Russia CDS auction presented investors with their best opportunity for months to buy or sell large blocks of Russian bonds. Strategists at JP Morgan said in a recent report that there were about US$2.4trn of Russia CDS to be settled across both single-name contracts and credit indices.

Russian debt prices, meanwhile, have staged a recovery since their nadir earlier this year as it has become more apparent that Moscow plans to continue paying bondholders that are not blocked by Western sanctions from receiving payments. That could be Russian investors or other institutions, such as family offices, for example, based in the Middle East or Asia. As a result, many see further upside for Russia debt from here.

“In March and April, [Russian] bonds were in the hands of investors that couldn’t get paid and the clearing price was very low,” said one credit analyst.

“Over time, these mechanisms and buyer bases have woken up to the fact that they could buy bonds in the 50s and could get paid at par. Maybe international investors who wish to keep these for the long haul will say: 'I’ve got bonds in the 50s; who knows? … they could be worth par. So, buying at 50 cents ... seems like a reasonable option to own'.”

Purchasing power

The CDS auction has two parts. First, bank traders provide indicative bids and offers on Russian debt, while also taking orders from clients that want to physically settle their CDS contracts. Those requests are then netted out to see if there is more demand to buy or sell bonds.

In the second round, that net demand is fulfilled through a "Dutch auction", where anyone can offer to buy or sell bonds through a dealer at a price they have determined in advance. The price at which the demand to buy or sell the bonds is finally filled becomes the final CDS settlement price for those opting to cash settle their contracts.

The average indicative price for Russian bonds was 48 cents in the first round, while the net interest of US$502m to buy bonds was eventually filled at 56 cents in the second round.

Protection sellers such as Pimco that opted to settle their CDS physically will receive delivery of Russian bonds in exchange for paying out to protection holders at par. Such a transaction leaves Pimco exposed to future fluctuations in Russian bond prices, suggesting the investment manager believes the market is undervaluing Russian debt at present.

"Those protection sellers that asked to take physical delivery of the bonds will now have to ride the bond risk going forward," said Athanassios Diplas, a former Deutsche Bank trader, who helped design the auction process.

“I think the CDS market will be relieved that the auction worked consistently with how it’s designed to work. The outcome really depends on which way the risk is going. This time, the physical settlement request was sizeable and the imbalance between buyers and sellers of bonds was enough to push the final CDS settlement price several points away from the initial midpoint and lower the payout somewhat."