Coco goes Loco!
26-05-2016 | by Pieter Jan van Krevel |
The title of this article does not pertain to mademoiselle Coco Chanel losing her marbles, nor to a small, furry animal going berserk over its squeaky toy. In this case, it refers to the Contingent Convertible bond (‘Coco’): a financial instrument that lately seems to have fallen from grace with the investment crowd.
While contingent convertibles exist on other securities for some time now, since the last financial crisis they have become quite popular amongst banks that use them to prop up their core tier 1 capital[1]. Similar to the hybrids from an almost bygone era, Cocos are hybrid securities that allow banks to consider them as equity. Why? Because they will either convert into equity, or be written off, if tier 1 capital falls below a preset threshold.[2] Cocos are (thus) heavily subordinated and carry a commensurate yield.[3] Or at least so it appeared.
Why then is their reputation going south? A first hiccup in their rise to popularity was caused by the implementation of the Basel III regime, under which not all Cocos are eligible for inclusion in tier 1 capital. Cocos with clauses on regulatory changes allow early redemption in that event, and when Lloyds wanted to call USD 5bn worth of Cocos on this ground, (legal) hell broke loose. Recently the UK Court of Appeal announced it would consider the previous appellate ruling allowing early redemption. The jury is still out, so to say.
This is not the only clause that can spoil the investors’ party. Common others are the issuer’s right to (indefinitely) skip interest payments, or postpone redemption. The latter can be as simple as just not call a callable perpetual, and thus ‘convert’ a Coco previously priced to first call in, say, 5 years, into an ‘real’ perpetual. Imagine what that does for NPV…!
Coco’s popularity took another hit last February, when rising concerns about Deutsche Bank’s performance – and even viability – triggered speculation about DB having to skip coupon payments on its Cocos, caused by some rather obscure accounting idiosyncrasy. Chaos quickly spread to other Cocos, bank stocks and bonds alike.
UBS‘ March 14 issuance of a new USD 1.5bn Coco proves things have quieted down somewhat, but investors have become more aware of both the complexity and the risks Cocos bear. It seems that the market is realizing that, as ever, there is no such thing as a free lunch. Not even a meagre loaf of coco bread.
[1] First Coco issued in November 2009 by Lloyds Banking Group, with Rabobank following suit in March 2010.
[2] Some, qualifying, Cocos are also referred to as ‘AT1’ – Additional Tier 1. These are considered the riskiest debt issued by banks.
[3] The 2010 Rabobank issue was e.g. priced at 300bps over a similar but non-convertible loan.
Owner at Slàinte Mhath!
Last week I visited an information session about financial postgraduate education. It was organized by the VU (Vrije Universiteit, Amsterdam). I noticed an increased interest in comparison to last years session, which is great. Information was provided about courses I see back in the CV’s of treasurers: CFA, RBA (Register Belegging Analyst) and of course RT (Register Treasurer) that has an overlap with the ACT courses. Education, specifically postgraduate, is a topic that returns in many of my meetings. This is what I notice on the topic:
Today in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the 
bought the option for 1.5%, we could sell it after 3 months at 1.1% and buy the USD through an outright forward transaction. This approach shows that the net cost of option protection would be only 0.4% (1.5% – 1.1%). Which would be cheaper than the premium of a 3-month option with the same Delta. Also, because the option has a higher Delta than a 3-month option with the same strike (25% vs 10%, see diagram 2), it will follow the spot market much better. The bottom line of paragraph 3 is that a longer dated option can be bought with the intention to sell it again at some point, the net cost being less than buying a shorter dated option. While it serves as a hedge against price changes.
buy the 1-year option in diagram 2 for 1.5%. Alternatively we could consider buying a right to buy this option for 0.4% in 3 months time. At that time the 1-year option will only have 9 months remaining, but the strike and 1.5% premium are fixed in the contract. On the expiry date of the compound option we can decide if we want to pay 1.5% for the underlying option. Alternatively, assuming nothing has changed, we could buy a 9 month option in the market for 1.1% (see diagram 2). In such a case we wouldn’t exercise the compound option.
Should we need to exercise the option to get our USD, it still means a combined hedging cost of 3.8%. Which is more than if we had bought the ATM option for 2% premium. Conclusion: Buying an OTM option reduces the up-front cost versus buying an ATM option. But ex-post hedging with an OTM option could result in total hedging cost which are higher than an ATM option.
option is exercised, or the USD must be purchased from the market at the prevailing rate.
Claire graduated as chemical engineer at the TU Delft. After an internship with JP Morgan she decided to pursue a career in the financial sector. She continued as investment banking trainee with ABN Amro / RBS and for almost six years, half of which in London, she worked in M&A and Corporate Finance. Since 2006 Claire was increasingly involved in renewable energy projects in faraway places (Antarctica, Himalayas) and from there on it was a small step to join Fastned and strengthen the team with her financial expertise.
