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CoCo Default Swaps Seen Fueling Bets Against Riskiest Bank Debt

The creation of credit-default swaps insuring contingent capital securities may spur bets against the riskiest bank debt.

“CDS changes everything because it allows you to short CoCos in a very efficient way,” said Jochen Felsenheimer, the Munich-based founder of XAIA Investment GmbH, which operates three credit funds. “I’m looking forward to having an instrument like this.”

The International Swaps & Derivatives Association is planning to introduce the contracts in September as part of a market overhaul aimed at strengthening credit protection, a person familiar with the matter said last week. The swaps will pay out when CoCos are written down or convert to equity after a lender breaches preset capital ratios, said the person, who asked not to be named because the discussions are private.

Contracts protecting CoCos will allow investors to hedge holdings or speculate on the performance of the bonds, which are overpriced and don’t sufficiently compensate for the risk of losses, according to Felsenheimer. The average yield on the notes fell 49 basis points this year to 6.39 percent, according to Bank of America Merrill Lynch index data.

“CoCos will be very, very tricky in a stressed scenario,” said Felsenheimer. “An instrument which is subordinated to equity and paying a relatively small coupon, which could be worth nothing at any time, I don’t think it’s well compensated.”

Issuance of CoCos is growing as lenders move to comply with new regulations making investors rather than taxpayers absorb bailout losses. Global banks have sold an equivalent 75 billion euros ($104 billion) of the securities since 2009 and sales will exceed 100 billion euros this year, according to an April 15 report published by Royal Bank of Scotland Group Plc.

“Right now, people are buying CoCos and buying equity puts to hedge them,” Felsenheimer said. “I could see doing the opposite. I could imagine being long equity and short CoCos.”

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