I Should Coco

Just imagine the scenario.   It's early-mid 2014, and while standard credit indices are doing just fine, there's a hot new asset in town that's blowing the doors down. 

These contingent convertibles have been around for a few years, but with banks keen to shore up Tier 1 capital ahead of the release of the ECB's  Asset Quality Review, they've been issuing like hot cakes.  Sure, they're converts, not traditional bonds, and there are some quirky aspects to them that make them difficult to price, but the yield is pretty tasty.

Fast forward a year, and high yield is looking ropy.   Investment grade's hanging in there, but the returns aren't fantastic.  Meanwhile, over the last year and a half the contingent coverts have generated a total return of more than 10%.   Is it any wonder that both banks (given the official imprimatur of the regulators) and investors (keen to clip juicy coupons in a low return world) said "I Should Coco"?

Now, of course, both sides are rather looking like Gaz in the Supergrass album cover above.   Having generated total returns of more than 13% over 2014-15, Cocos have given it all back and more so far this year.  All of a sudden that boring IG index isn't looking too shabby....

One of the main issues with Cocos is the heterogeneity of the product.  All have some sort of trigger, but some convert to stock and others wipe out a portion of the principal.   Some, like the infamous DB 6 percents, suspend coupon payments if the issuer doesn't have enough spare change.  Many have triggers based not only on book or market value, but also on the discretionary judgment of a regulator.  Oh, and they all seem to have prospectuses of 130 pages, which Macro Man would be willing to wager were not exactly diligently studied before many of these deals were bought.

Much like the world of exotic options, introducing barriers and triggers generates a great deal of non-linearity into pricing.  Part of this non-linearity gives the owner of many Cocos an embedded short gamma position to the downside; i.e., they own the bonds and they're essentially short puts against it.  Surprise, surprise, that free yield wasn't so free after all, and when stock prices fall Coco holders are forced to sell as a hedge.  Thanks to the ECB and their own endeavours, that seems to be exactly what's happened to DB.

Now one of the features of short gamma is that it can produce nasty overshoots that lead to reversals that are just as nasty.  Perhaps that will be the outcome here.  However, even a gamma-led bounce does little to assuage the impact of negative rates, and one would have to think that the current episode has certainly raised an appreciation for the embedded risks in Cocos as an instrument, tempering enthusiasm for them moving forwards.  It's a timely reminder of the lesson that enthusiastic diners on AAA rated ABS turdburgers learned in 2007; if something seems too good to be true, it generally is.

That being said, the malaise affecting the global banking sector looks to be about a lot more than Cocos, or even negative rates in certain jurisdictions.  Worryingly, the global sell-off has been unusually synchronous, even in places like the US where Cocos did not get the blessing of the regulators and the Fed has yet to pursue NIRP.

It's a holiday in Japan today; lord knows they need it.  The Topix bank index is down 23% in the less than two weeks since Kuroda made what now looks to have been a horrible mistake, closing at 133 on Wednesday.   To get an idea of how painful that is, Macro Man had a friend run a VWAP on the Daiwa Topix banks ETF for the last year.   The closing price on Wednesday was 138; the 1 year VWAP was just under 204.   Gulp.

As for USD/JPY, the warnings presented in this space over the last few weeks have come to pass, with necklines and clouds broken with alarming ease.  Macro Man would caution to account for the Japanese holiday in your assessment of recent price action, as well as the possibility that the GPIF or Kampo might magically decide to bid on some dollars when they get back to their desks.   That being said, the chart is pretty clear, and Macro Man reckons that "goodnight Irene" implies ~105 eventually.

In a way, it would by a fitting symmetry a la the FANG/GDX chart presented a few days ago.  After all, that was the low during that crazy period in mid-October 2014 before Kuroda-bomb #2 shocked markets and sent USD/JPY on a rocket ship ride.  The only thing that could make it worse is if we found out that Mrs. Watanabe has been stocking up on Cocos...