(Bloomberg) -- The pitch from Wall Street sales desks to clients goes something like this: Block out the horrors of the war in Ukraine, and focus on the trading opportunity it has created. Years, even decades could go by, one hedge-fund firm recalls being told, before another relative-value trade this attractive comes along.

For those comfortable with step one, the bet has indeed racked up quick gains. Known as a negative-basis trade, at its core it takes advantage of the near-unprecedented selloff in Russian debt since Vladimir Putin’s widely-condemned invasion. It involves buying beaten down government or corporate bonds along with corresponding credit-default swaps, which insure the debtholder in the event of non-payment.

In normal times, the economics of such a transaction don’t make much sense. The cost of the debt and the hedges move inversely, typically offsetting each other. But for much of the past month, as institutional investors were rushing to offload their stakes in Russian assets amid mounting public outrage, bond prices were falling faster than the cost to hedge was rising.

“It seems like a quasi-guaranteed trade,” said Jochen Felsenheimer, a managing director at XAIA Investment in Munich, where he trades both CDS and bonds. Felsenheimer said he’s observed “very active” buying and selling of negative basis, with packages seemingly assured to pay out at par quoted recently at 80 cents on the dollar.

Rob Citrone’s $2.6 billion Discovery Capital Management is one of the firms taking advantage of the kink in the market. Discovery bought long-dated Russian government bonds at about 20 cents on the dollar, while also hedging with one-year CDS at a price of around 60 cents, according to a person with knowledge of the trade. 

In essence, if the country defaults, the firm can convert the near-worthless bonds into cash and pocket a substantial profit. And if it doesn’t, the notes could quadruple in value, or more. The arbitrage position accounts for a couple percentage points of Discovery’s portfolio, the person said.

Other firms including Aurelius Capital Management, GoldenTree Asset Management and Silver Point Capital have been piling into Russian markets, primarily by snapping up corporate bonds, the Financial Times reported last week. And H2O Asset Management has told investors that it’s been adding to its Russian debt holdings, according to a client letter seen by Bloomberg.

But ask around hedge fund circles and, beyond H2O, few will admit publicly or even privately that they’re getting into Russia. Discovery, Aurelius, GoldenTree and Silver Point all declined to comment for this story.

Rarely has a trade elicited such fierce industry debate, according to distressed-debt veterans, a group known for its combative personalities and aggressive tactics. Not only about the moral and ethical repercussions but even more so over the inherent financial, legal and reputational risks that come with investing in the country.

As much as firms are trying to cover their tracks, signs of their involvement are all over global debt markets.

Volumes in Russian corporate bonds soared to their highest levels in two years last month, according to data from MarketAxess. Moreover trading of Russian credit-default swaps has surged, dwarfing other single-name contracts, Bloomberg data show. 

At the same time, the nation’s government bonds have almost tripled in value over the past three weeks, with dip buyers bidding up prices as the Kremlin manages to navigate a complex web of international roadblocks to ensure foreign creditors still get paid.

“The appealing part for investors is the asymmetric payoff -- how much money you could make,” said Jean-Dominique Butikofer, head of emerging-markets fixed income at Voya Investment Management, which isn’t involved in the trade. He noted that some hedge funds did very well wagering on Russia in the aftermath of the country’s 1998 ruble devaluation and default. “That may be on their minds.”

The steady climb in Russian bond prices in recent weeks has eroded some of the arbitrage opportunity in the negative-basis trade already. Bond and CDS packages more recently were being offered by sales desks for as much as 95 cents on the dollar, traders said. Others say they can still be had in the 70 cent range.

‘Uninvestible’

Yet for many, there’s seemingly no price that could compel them to get involved.

The country “has become uninvestible for most in the West,”  Marathon Asset Management’s Bruce Richards said in an interview. He noted that the firm doesn’t have any exposure to Russia outside of index products that will soon remove the country. “Russia may have the willingness and ability to pay its debts,” he said, but “this unimaginable aggression Putin and Russia have embarked upon will ultimately lead to a collapse of the Russian economy.” 

While an economic collapse may sound hyperbolic, mounting sanctions on Moscow are already beginning to take their toll. With half the nation’s foreign-exchange reserves frozen, the ruble plunged in early March. Inflation will surge to 18% over the course of the year, according to Bloomberg Economics, while the country’s GDP is expected to contract almost 10% in 2022.

Even if Russia wants to pay its creditors, there remains the question of mechanics. While the Kremlin has managed to make interest payments on a handful of bonds over the past month, last week the country said operations via Clearstream, one of the biggest clearinghouses in the world, haven’t been going through after its account was blocked, raising questions over how easy it will be to send cash to creditors in the future.

Settlement Risk

The negative-basis trade seemingly insulates investors from such risks. Still, some say the unorthodox language in certain Russia bond documents, along with uncertainty over sanctions, could raise issues about when default swap contracts are triggered and how they are settled.

Future U.S. Treasury restrictions on Russian bonds, for example, could make the debt non-deliverable at CDS auctions, complicating the ability of holders to get paid.

Jay Newman, the hedge fund veteran behind Elliott Management’s 15-year battle with Argentina following that nation’s default, said in an interview with Bloomberg that even experts in sovereign debt can’t make reasonable bets on Russia given the extreme variables at play.  

“It’s something no one in the distressed sovereign or corporate market has ever seen before,” he said of Russia’s default prospects, noting in particular the atypical immunity clauses the government has maintained in its debt documents, protecting it from foreign lawsuits. “Specialist investors have never faced something like this, and crossover investors have certainly never faced it.”

There’s another, less tangible risk that fund managers must consider, warned Newman. Firms face long-term reputational damage by linking their names to Russia. That’s why many public institutions and pensions were quick dump Russian assets at the outset of the war. “There’s a lot of pressure being brought to bear on managers to not have Russia on their books,” Newman said.

To avoid backlash, some fund managers have created private side accounts for clients seeking Russian investments, according to people with familiar with the matter. The vehicles are meant to keep securities out of primary funds where they could attract criticism from other clients.

Julian Brigden, a managing partner at hedge-fund consultant Macro Intelligence 2 Partners, said some U.S. money managers have been weighing the merits of setting up offshore structures in order to buy Russian assets.

Others, he said, “would never in a million years” expose themselves to such a high level of scrutiny.

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