January 31, 2014 / 3:26 PM / 4 years ago

Investors search for CoCo hedges

(This story originally appeared on IFRe.com, a Thomson Reuters publication)

* Industry weighs potential for CDS tied to CoCos, but a separate instrument might be needed

By Christopher Whittall

LONDON, Jan 31 (IFR) - The flood of contingent convertible debt issuance from banks has met rampant demand from yield-hungry investors, who are now turning their attention to identifying effective hedges for this burgeoning new asset class.

Questions remain over the development of a credit default swap market aimed solely at CoCos, though, with investors currently having to make do with credit indices and equity put options to hedge their positions.

“CoCos and hybrids are blossoming areas of the credit market. There is a regulatory need to issue Additional Tier 1 in particular - this is a market that has to exist and needs to work, and investors are gravitating very quickly to these products because of the yield,” said Barnaby Martin, a credit strategist at Bank of America Merrill Lynch.

“But we know we’re in a market where investor positions can become too crowded. Now we’re in a world where it’s difficult to shift a lot of bonds, it’s interesting to look at what investors can do to hedge against volatility.”

European banks will be pushed to issue more than EUR500bn of AT1 and Tier 2 debt to meet capital requirements imposed by CRD IV, according to Citigroup estimates, with EUR20bn and EUR45bn of issuance, respectively, forecast for this year.

It is hardly surprising then that banks are keen to make the asset class as attractive as possible to potential investors.

BofA Merrill, for example, is compiling a benchmark index to lure a wider array of real money managers to the product .

Some see the creation of a complementary CDS market as another way to boost liquidity by allowing investors to purchase protection against potential losses on their cash bonds.

Financial CDS are some of the most actively-traded contracts in the market. However, attempts to branch out beyond senior and subordinated CDS to loans or old Tier 1 bonds have previously failed to gain traction.

Moreover, financial CDS have lost some credibility in the eyes of many following the nationalisation of Dutch lender SNS Reaal last year. Despite sub debt holders getting completely wiped out, protection holders received no payment on their sub CDS contracts. ISDA is leading an overhaul of CDS to fix these flaws, with a launch date of the new contract scheduled for March 20.

“CDS are not appropriate for hedging after what happened with SNS, but the upcoming changes might help,” said Michael Huenseler, head of credit portfolio management at Assenagon.

“Since CoCos can convert without actually triggering a credit event, I‘m convinced there needs to be a separate instrument in addition to sub CDS to hedge CoCos - a special CoCo sub debt CDS.”

Edmund Parker, head of the derivatives practice at Mayer Brown, said it should be possible to draft a CDS contract on CoCos. “I think the bigger problem would be getting people to write protection,” he said.

Others doubt an effective instrument could be fashioned, though. “CoCo CDS will be difficult - it’s hard to see what would be the trigger as the key feature of these bonds is the ability for the bank not to pay coupons,” said one credit hedge fund manager.

TAIL RISK HEDGE

In the meantime, investors are resorting to a variety of hedges for their CoCo portfolios. Huenseler said his firm tended to be quite conservative and bought out-the-money put options as a tail risk hedge.

“In the case of a default, the stock price will clearly collapse, which makes a put option suitable,” he said.

However, Huenseler highlighted the importance of monitoring the correlation between CoCos and equity options, particularly where it was likely that the bonds might be called. “You need to take into consideration how much they’re trading like equity or whether they have other dominant fixed income features,” he said.

Martin at BofA Merrill examined the performance of various hedges over the past year and, in particular, during the “taper tantrum” of last May and June.

While equity might provide good tail risk protection, there wasn’t a great correlation to CoCos over this period, suggesting it is a poor hedge for mark to market moves. Credit indices appear a better option for those wanting to shield against paper losses.

“We found Crossover had the highest correlation to CoCos during the taper tantrum last year, which makes sense because it was a systemic risk-off moment,” said Martin. (Reporting by Christopher Whitthall, Editing by Helen Bartholomew and Matthew Davies)

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