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Cocos: An Overview of the Anti-Convertible Bond

Eli Pars

Contingent convertible bonds, or cocos, have been getting more global press recently, including in this past Friday's Financial Times. As one of the world's oldest and largest managers of convertible strategies, we are asked about cocos frequently. In many ways, a coco is the mirror image of a convertible bond. Instead of the equity upside participation and potential downside protection that can make a convertible bond so attractive, cocos may have much higher potential downside.

A convertible bond is a corporate bond that allows the holder to convert into a fixed quantity of shares in that company's common stock. If things go well and the stock rises, the convertible bond holder participates in the rising stock price, capturing equity upside. If the stock falls, the convertible is still a bond and the holder receives a fixed coupon and par at maturity. Think of a convertible bond as a security that looks like a stock if things go well and like a bond if things go poorly.

Cocos are also hybrid securities, but the similarities to traditional convertibles pretty much end there. Banks issue cocos to meet regulators' requirements for capital reserves, and to provide a cushion should they find themselves in a serious predicament. Cocos typically pay higher coupons than a bank's straight bonds. However, if the bank gets in trouble (think 2008), these bonds turn into equities. Think of them as anti-convertibles. I also like the term "Bizarro" convertibles, to borrow from Superman comics and a Seinfeld episode. If things go well, you just get your fixed coupon and par back at maturity. But if things go poorly, you quite likely will get little to nothing in return. After all, if a bank is in bad enough shape that its cocos convert into equities, that bank stock you are getting may not be worth much. In many cases, it won't be worth anything at all. Cocos have become quite popular with banks in Europe; we believe they will probably end up being used in other markets as well.

These securities are not your father's (okay, older brother's) cocos. Originally, "contingent convertible" described convertible bonds that were convertible into the equity only after the stock had risen to where the bond was well into the money. These contingent convertibles became popular in the U.S. around 2001 and had some accounting benefits for the bond issuers. The term wasn't applied to bank hybrids until several years later.

In our convertible portfolios, we're focused on upside equity participation with potential downside protection over full market cycles. Because the risk/reward profile of these bank cocos is the opposite of the risk/reward profile we look for in convertible bonds, we are quite willing to pass them by.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. Convertible securities entail credit risk and interest rate risk.

Convertibles that are in the money have a stock price above the exercise price.

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