Investors are tired of hedging against unrealised tail risks. That much we know.
What happens, though, when that tail risk does emerge and investors rush to hedge the unthinkable, once it’s a bit more thinkable? Please meet the CoCo death spiral.
There’s been talk of this before — specifcally, the idea that once a bank hits its CoCo trigger and has to convert the bonds into equity, CoCo investors will have to sell the resulting shares. UBS banking analysts Alastair Ryan and John-Paul Crutchley have an example of such a spiral in a 16-page research piece on CoCos out this week.
But they go a step further; beyond simply selling the shares.
They’re talking about the possibility of CoCo investors selling their convertible bonds or shorting the bank’s shares to act as a hedge against the CoCo trigger. CoCos and shares come at the bottom of a bank’s capital structure — which means they’d be the first to ‘react’ to the risk of bankruptcy — at which point you’d have that spiral effect.
Here though, is a worked example, concerning Lloyds’ CoCos:
As a brief example of the potential scale of this risk, Lloyds now has around £7.5 billion of enhanced capital notes (ECN) outstanding – its own form of CoCos … Lloyds has delivered impressive improvements in balance sheet strength since its ECN issues in late 2009, with a core tier 1 ratio up to 10.2% and more than £60 billion in term funding raised since the beginning of 2010.
With the ECN conversion trigger set at 5% and Lloyds strongly capital generative, we believe few owners of the ECNs are hedged as their conversion into equity is so unlikely. However, should conversion become considered significantly more likely, due to a significant change in the company’s or the UK’s outlook, we believe the holders of these £7.5 billion of securities would likely choose to hedge the risk of being delivered stock by selling the shares short. Their net position is equivalent to 79 days’ volume in the shares. Any attempt to sell this amount of stock short would likely cause a significant decline in the share price of any company … for a bank, such a move has been typically linked with financial weakness by customers and counterparties.
Ironically, the best hope for banks to avoid the death spiral might be for CoCo investors to refrain from hedging at all. Which, according to the UBS analysts, many of them have already been doing since advance hedges are quite difficult to model.
That said, that doesn’t mean investors won’t start hedging through selling/shorting nearer to the trigger point — at which point you might just get that death spiral.
On the plus side, the two UBS analysts do figure that (given the things look set to stay, anyway) CoCos will, erm, help banks increase their leverage and their returns.
Anyway, you don’t need to worry about this for now. The UBS analysts reckon banks currently issuing CoCos are those that are probably the least at risk of converting:
CoCos issued in the near future will typically be from those banks most comprehensively recapitalised and derisked within this environment. Therefore, it may well prove that the CoCos most likely to crystallise the risks highlighted earlier in this report will be issued by a group of banks some years hence, and those to be issued in the coming months prove indeed to be fundamentally fixed income instruments in practice.
The risk of existing CoCos being triggered is remote — a tail risk event.
Oh. Wait.
Related link:
An accounting boost for CoCos – FT Alphaville