(Updates with analyst comment in final paragraph.)
April 17 (Bloomberg) -- The International Swaps & Derivatives Association is creating credit-default swap contracts for contingent capital securities, according to a person familiar with the matter.
The swaps will pay out when the riskiest bank debt, known as CoCos, convert to equity or are written down after a lender breaches preset capital ratios, according to the person, who asked not to be named because discussions are private. Nick Sawyer, a London-based spokesman for ISDA, declined to comment on the plans.
Issuance of the debt designed to absorb losses in times of stress surged to the equivalent of 75 billion euros ($104 billion) worldwide since the first notes were issued in 2009 and will top 100 billion euros this year, according to Royal Bank of Scotland Group Plc. CoCos aren’t protected by existing derivatives rules and ISDA is drafting changes to take effect in September, the person said.
“The market for contingent capital will grow further, yet some investors are still skeptical about it,” said Alberto Gallo, head of European macro-credit research at RBS in London. “Other investors instead are lured by the high nominal yield and perhaps some are buying without full awareness of the risks and complexity.”
The risk of losses on CoCos is not fully priced into the securities, Gallo said. Yields on Bank of America Merrill Lynch’s Contingent Capital Index declined 57 basis points this year, giving a total return of 3.72 percent.
The CoCo market is growing as lenders move to comply with new regulations aimed at passing bank bailout costs to investors rather than taxpayers.
The CoCo swap contracts are being drafted to apply to Swiss banks and may later be adopted more broadly, according to the person. Swiss requirements for levels of bank capital are more stringent than in other countries.
ISDA is planning to introduce broader changes to rules governing credit-default swaps on Sept. 20, when new series of Markit Group Ltd.’s benchmark indexes based on the contracts start trading. It’s the biggest overhaul of the $20 trillion credit derivatives market in more than a decade and aims to address flaws revealed during the financial crisis.
The list of credit events that trigger payouts will be expanded to include bail-ins, when investors are forced to contribute to bank rescues, along with bankruptcy, failure-to- pay and restructuring. The CoCo swaps are being developed as a supplement to the broader changes, the person said.
Trading in Markit’s subordinated financial index has slumped, with contracts on the current version of the benchmark covering a net $1.8 billion of debt as of April 11, according to the Depository Trust & Clearing Corp., compared with $4.3 billion on the equivalent measure a year ago. A net $10.4 billion of protection is outstanding on the measure for senior debt.
The cost of insuring lower-ranking debt has also tumbled as investors shun existing protection in anticipation that future contracts will be more effective. The Markit iTraxx Subordinated Financial Index of swaps on 25 European banks and insurers fell to a more than four-year low of 118 basis points this month and now costs 122 basis points. Without credit-default swaps, traders typically use equity options to try to hedge CoCos.
“Using CDS as a hedge sounds like a better idea than using equity,” said Robert Montague, a credit analyst at ECM Asset Management Ltd. in London.
--With assistance from John Glover in London.