As investors, the majority of our time is spent pricing risk with an increasing amount of that spent trying to value optionality. We’ve always had to price the optionality inherent in owning certain bonds. For instance what’s the likelihood of a call option sold to a bond issuer being exercised? What’s the likelihood of an early refinancing, or perhaps a change of control? These and other options are both risks and opportunities that credit investors will regularly have to consider and reconsider.
Some of the more recent options that credit investors have been forced to consider are those embedded within contingent capital notes or CoCos. These aren’t entirely new securities with Lloyds having exchanged bonds for CoCos back in 2009. Simplistically these ‘first generation’ CoCos are designed to behave like a traditional bond until a pre-defined trigger is breached. When triggered, first generation CoCo holders are forcibly converted into equity at pre-determined pricing, aiding the bank with its recapitalisation efforts. These instruments have found favour with the regulator not least because traditional subordinate capital instruments proved themselves almost entirely ineffective in providing loss absorbing capital.
However, since the issuance in 2009 the market has moved on somewhat and a new breed of CoCo has since emerged. Many of these newer instruments (see chart above) are designed to be written off entirely in the event of a trigger without the conversion into equity discussed above. This optionality has two obvious implications. Firstly, given that investors are written down to zero without equity conversion, any prospect of participating in a future recovery becomes null and void. Secondly (with the caveat that the quantum of issuance remains small for now), the prospect of a bond essentially performing the role of a non dilutive emergency rights issue has to be positive for all other stakeholders in the bank, not least common shareholders. And don’t forget that the majority of these instruments will see their coupons paid before tax, further enhancing the relative value of said issuance.
Selling all this optionality does have its price, as do most things in life, but the current exuberance in credit markets may yet see CoCo investors fail to exact an adequate premium.