A little-known piece of financial machinery designed to reduce risk may be one of the culprits behind recent turbulence in global bank stocks.
Contingent convertible bonds – which go by the charming nickname of "cocos" – are a relatively new type of debt, widely used in Europe, that is designed to provide a buffer for banks during times of stress. Cocos typically provide this relief by automatically being converted into common stock when calamity strikes.
Banks under pressure stand to benefit from the debt-to-equity switch in two ways – they suddenly have less debt to pay interest on and they also gain a deeper pool of equity to absorb any losses. In a financial crisis, that helps to ensure the continued viability of troubled banks, which is good news for everyone.
However, the devil is in the details and recent ructions in global markets may reflect cocos' unforeseen capacity for creating mischief.
The investors who buy cocos typically do so because the coco bonds offer a higher interest payment than other debt. This extra payment is designed to offset the risk that the bonds may suddenly be transformed into stock at just the worst time.
As a result of those tempting payouts, cocos have been bought by many funds in search of rich yields. Of course, those same high-yield funds have been hammered recently as the carnage in the energy sector has pounded many of their holdings.
This is where things get interesting. "Given what has happened in the energy square, the high-yield funds are getting slaughtered and are being redeemed," writes an institutional investor on Bay Street who would prefer not to be named. To meet the redemptions, the funds have to sell whatever they own and this puts particular pressure on the prices of thinly traded cocos.
The funds that hold or are looking to sell cocos are searching for ways to hedge their exposure to the area. To do so, they short the common stock of the bank that has issued the cocos and they buy credit default swaps on the bank's debt.
Both are bets that will pay off if the bank continues to deteriorate, thus offsetting losses on the cocos. (A short position in a stock makes money if the stock price goes down. Meanwhile, a credit default swap is essentially insurance against default, so the value of the swap goes up if a bank's fortunes decline.)
However, shorting stock and buying credit default swaps can result in some dramatic movements in the relevant markets. That's what may have happened in recent days, especially in the case of Deutsche Bank, which issued many cocos.
The German giant's stock dropped sharply while the price of credit default swaps on its debt jumped skyward. The abrupt moves helped to spook investors and led to a major sell-off in bank stocks in Europe and around the world.
"This is clearly not the only reason the shares are down or the credit default swap is up – there are real profitability issues with the banks and the fear in the marketplace is real – but I think the actute nature of the move can be explained by the above," writes the institutional investor.