What’s an “equity like” product in the credit market? February 1, 2014 at 3:15 pm

FT alphaville quote this chart from BAML in an article about (amongst other things) Cocos:

Frozen rain

It strikes me that leveraged loans are not much like Cocos. Think of it this way. Start with a senior bond from a good quality issuer. You can make this product more ‘equity like’ in a number of ways:

  • Make the issuer dodgier, so the credit spread goes out to reflect the increased PD;
  • Make the bond more subordinated, so the loss given default goes up;
  • Make the coupons deferrable/PIK’able, creating a risk of loss without a credit event;
  • Make the bond mandatory convertible or bail-in’able so that you can get something other than par back, again without it being a credit event.

Doubtless there are others. The point though is that the first direction – drifting down the credit spectrum towards leveraged loans – slowly moves the loss distribution; whereas the last two add an unlikely but catastrophic event. Cocos or bail-in bonds from good quality banks are unlikely to suffer losses, but when they do, they are bad. This is a different kind of ‘more like equity’ than declining credit quality.

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