How much for that Coco in the window? December 24, 2009 at 7:34 am

An interesting observation from Financial Crookery about the Lloyds Cocos:

the 15% ECNs were indicated at 122/123 on minimal volumes, compared to 110/112 for the previous 13% series. Absent the EU-mandated 2 year coupon pass for the 13% security for “burden sharing”, the 13% notes would have been trading around 132/133, so credit markets value the trigger risk at around 10 points higher than the additional 2% coupon. Is this enough? How should the ECNs be valued?

In exchange for protection from regulatory cashflow interference and the coupon hike, investors add a “wander to loss” risk to the pre-existing “jump to default” risk. These two volatile processes are correlated, and can be modelled to value the ECN. It is essentially a 15% bond which knocks-out if either (i) Lloyd’s book value falls around 45% during the 10 years, returning the value of the (correlated but more volatile) stock price at that time or (ii) Lloyds jumps to default in the normal credit way.

I am conscious of the jaundiced reader’s likely view of model-based pricing. Nevertheless my own valuation of the ECN using this framework was in the 115-120 range(1). The cost of the “wander to loss” risk is higher than credit markets are estimating. The current ECN quote is not particularly cheap on this reckoning, particularly as the ECN would usually trade at some discount to theoretical value. In short, I think the stampede to exchange may have been misguided.

The model used could be questioned – in particular using a 2 factor random walk with correlation strikes me as a rather simplistic way of modelling the joint equity/book process, especially for a credit like Lloyds with a lot of different kinds of subordinated debt – but it is still a pretty reasonable start.

The only question remaining is why the market values the Co-Co’s so generously. The answer may be surprisingly straightforward: a hunger for yield, maintenance of current income and resolute belief in the sovereign put.

I suspect the high coupon is also attractive to those playing tax games. High interest income certainly used to be necessary in some tax ‘structuring’ (aka defrauding the ordinary tax payer).

Furthermore, some capital structure arbitrage players, assuming there are any left, would be hedging the note with purchased protection on Lloyds sub debt. That would be a classic short credit gamma long carry position. And we know how well those sometimes work out…

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