LONDON Investors eyeing bonds from near-bankrupt Cyprus are not convinced by policymaker promises that Greece's 2012 debt restructuring was unique and fear they too may face imposed losses.
But not everyone is put off and some of the funds that made a fortune as Greece tried to get its finances in order are licking their lips at the prospect of juicy returns on Cypriot bonds.
Having just elected a reform-minded president in Nicos Anastasiades, Cyprus seems to be heading for a bailout deal in March or April that would keep it afloat.
Cyprus's large debts relative to the size of its economy, allegations it is a hub for money laundering, and talk of imposing losses on bank depositors lead many to think, however, that a restructuring is on the table as well, though this is denied by Cypriot and euro zone officials.
For many hedge funds looking at Cyprus this risk, which they say markets underestimate, means that by waiting until it looms larger, they could snap up government bonds more cheaply.
They could then profit if the island avoids default, if it does restructure but the funds can stay out of the deal or if they get a better price in a potential Greece-like bond swap.
"It is best to wait," said Sohail Malik, lead portfolio manager for the ECM Special Situations hedge fund.
"With no haircuts on debt or deposits it's unclear exactly how Cyprus will delever over time. They will just extend the same unsustainable debt levels... Something has got to give."
Crippled by its exposure to Greece, Cyprus needs about 17 billion euros from the euro zone to recapitalise its banks and avoid a government default.
Although the sum is a fraction of Greece's 130 billion bailout, it is almost as much as the size of the economy. Part of the money will be used to repay a slice of the 15 billion euros Cyprus owes, but it would still raise the debt to as much as 140 percent of output, a level widely seen as unsustainable.
Malik estimates Cyprus's 2020 bonds, which trade at around 76 cents in the euro and yield about 9.5 percent, are pricing in a 15-20 percent chance of default. He says a more appropriate price would be "in the 60s", reflecting a 40 percent chance of default.
Another buyside investor active in distressed sovereign debt markets said he saw two main scenarios for Cypriot bonds, both negative. The first was that the growth forecasts on which the terms of the bailout deal will be based will prove, as with Greece, too optimistic, warranting a debt restructuring.
The other was that Cyprus could soon ask investors to accept maturity extensions before a 1.4 billion euros bond last yielding about 22 percent, matures in June.
By waiting longer for repayment, investors are effectively taking losses on their holdings.
Given the risks, a "fair price" for the 2020s would be 70 cents in the euro, said the investor, who asked not to be named.
Hans Humes, chief investment officer of Greylock Capital and a veteran of distressed debt markets, is holding some of the June 2013 bonds on the view that there was not enough time to agree on a restructuring -- talks on Greece's deal lasted seven months. In that case, the default risk would rise, he said.
LNG Capital and Adelante Asset Management are two other hedge funds which, having invested in Greece, are looking at Cyprus for any potential opportunities.
According to distressed debt brokerage Exotix, the Cypriot bonds that hedge funds trade are issued under international law -- about 60 percent of the outstanding paper, Morgan Stanley estimates -- because they are harder to restructure.
The fact that the majority of bonds are under international law is a major reason why the 2020s bonds rebounded from lows of around 50 cents hit in mid-2012 when Cyprus first asked for a bailout, Exotix chief economist Gabriel Sterne said.
Three quarters of creditors need to agree to change the terms of bonds under international law. In Greece, whose debt was mostly under domestic law, a retroactive collective action clause meant only half of the bondholders needed to vote and just two-thirds of those needed to agree on the restructuring.
"Most people think that it's unlikely they'll find a clever way of forcing people in like they did in Greece," Sterne said.
However, a paper by Cleary Gottlieb Steen & Hamilton lawyer Lee Buchheit, Duke Law School's Mitu Gulati and Universidad Autonoma de Madrid's Ignacio Tirado, has unnerved hedge funds.
Buchheit has crafted or advised on debt restructurings for the past 30 years, including those in Greece and Iraq, building himself a scary image in the hedge fund world.
The paper argues a minor tweak to the treaty establishing the European Stability Mechanism -- the euro zone's bailout fund -- to immunise the assets of a country receiving financial aid would prevent creditors from holding out against a restructuring by making legal claims against the government more difficult.
Hedge funds, and some economists, argue that this would raise fears that the euro zone plans to deal with its three-year-old debt crisis by imposing losses on private debt holders, sparking a sell-off in markets such as Italy or Spain.
The funds hope the risk of contagion to other euro zone countries will stop policymakers endorsing the proposal.
"There always seems to be political willingness to involve the private sector," said Greylock's Humes. "If the euro zone does what Buchheit suggested in the press ... there is an extremely serious risk they reignite the euro zone crisis."
(Additional reporting by Laurence Fletcher, editing by Nigel Stephenson)