Jun 29, 2015

Trend Spotting in Brazil: Contingent Convertible Bonds on the Rise

In this video blog Dr. Meng Lu, Senior Vice President of Financial Engineering provides key insights from the recent Bonds, Loans and Derivatives conference in Brazil where he spoke on a panel focusing on pricing dynamics of Brazilian debt instruments. Meng elaborates on the high interest rate environment in Brazil and how it’s impacting the local market in terms of investing abroad, securing funding and managing FX risk.  He also addresses the rise of contingent convertible bonds or ‘CoCos” discussing how they structured, how they work and what they are being used for.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section.

Video Transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog, your expert source for derivatives trends and topics. I’m your host Jim Jockle. Joining me today is Senior Vice President of Financial Engineering, Meng Lu, Meng welcome.

Meng Lu (Guest): Thank you.

Jockle: So, why don’t we just jump right in­–you spoke on a panel focusing on pricing dynamics of Brazilian debt instruments. So why don’t we just start there, perhaps you can give us a little bit of a recap of some of the discussions during the panel.

Lu: Sure. So this conference in San Paolo was about derivatives loans and bonds in the Brazilian market. And there are a couple hundred participants in this conference, very well organized. And, there are a couple takeaways from this conference that I learned. One is that due to the very high interest rate in Brazil around 13%, which is the equivalent of the US LIBOR rate, so that’s quite high. So, the local players, in order to achieve the return they want to achieve they actually don’t have the need to go abroad to achieve that kind of return, they can just stay local. That’s one thing that I learned.

And the other thing is if you look at the corporations who need funding. So these corporations obviously want to pay as little as they can, so for these guys, they actually go abroad to look for cheaper funding. Typically they can achieve that kind of funding in either the US or in Europe, which has even a lower rate than the US.

So for these corporations while they can achieve this cheaper funding, but the other thing that they have to be concerned about is the FX Risk, obviously there is no free lunch, so they have to do the FX hedging when they bring the money from abroad to Brazil.

Jockle: So one of the other elements that seems to be on the rise is the issuance of CoCos coming back to the Brazilian market. What it is about the market that has made it right for this type of debt instrument.

Lu: Yes, that’s actually very interesting. There is a dedicated session just for that topic and they literally flew someone all the way from Singapore DBS to talk about this thing with a few local people. So if you look at convertible bonds, which is definitely not new, US Market, European Market, they have had convertible bonds for many, many years. What is slightly new is this so-called contingent convertible bonds also called CoCos.

If you compare the traditional convertible bonds vs. the contingent convertible bonds, the difference is that for the traditional one, when the equity market is doing well the bond holders have the incentive to convert.

But for the CoCos, it’s just the opposite. The right to convert actually belongs to the bond issuers, whether or not that’s a financial institution, or a regular corporation. So obviously for these issuers, they only want the conversion to happen when the equity is not doing well, just the opposite as the regular convertible bond. So, what we have learned is that this CoCos has been becoming quite popular in Europe and in Asia; for whatever reason, not so much in the US and one of the panelists talked about one of the Brazil corporations just issued the first CoCos ever in the Brazilian Market and there are a lot of discussions about the pricing aspect of it, the legal aspect of it, because this type of instrument seems to be pretty new in Brazil and there has been quite a bit of an interest in this new type of product.

Jockle: So, one of the challenges I think as it always relates to the Brazilian Market is the distinct elements of the profiles of derivatives. Whether it’s the calendars conventions that are very unique. Within CoCos, is it more of a standardized cross border type product or are there other distinct features to the Brazilian Market.

Lu: CoCos tends to be quite bespoke; every one of them is different, and there are different kinds of features that the bond issuers can build into the terms and conditions. For example, under what condition the issue can convert, forced conversion, and there’s barriers that you need to hit, you know, things like that. So this is definitely not a standard product.

Jockle:  And are you finding discussions around transparency in terms of whether it be documentation or understanding payoffs, of those conversion elements being built in, kind of more prolific from the last time we’ve seen CoCos come to market.

Lu: The transparency is one of the key topics people are interested in. So, for example, one of the bonds I’ve seen is essentially the board of directors can determine when they can force the conversion. And that determination obviously it’s a little bit arbitrary, you don’t know when they’re going to hold the meeting, when they are going to decide when they force the conversion.

However, from a modeling perspective, you can actually approximate the situation. For example, equity goes down a certain level, then it’s likely, very likely, that the board of directors will determine the conversion. So, that kind of thing can be modeled to a certain extent, even though it’s not a black and white kind of thing.

Jockle: Well Meng, thank you so much for joining us. And of course, as we see the continued proliferation around CoCos we’re going to have some more questions, so I do hope you’ll join us again.

Lu: Sure, my pleasure.

Jockle: Thank you, Meng. And of course, On the Numerix Video Blog, it’s our goal to examine the topics that you want to talk about, so keep the conversation going on LinkedIn and on Twitter @nxanalytics.

“Provisionally Popular: Contingent Convertible Bonds” [Graphs] 2015. Retrieved from The Economist: http://www.economist.com/news/finance-and-economics/21617028-investors-are-panting-risky-new-form-bonds-issued-banks-mass-conversion

“Hot Issue” [Graph] 2015. Retrieved from The Wall Street Journal: http://www.wsj.com/articles/emerging-market-cocos-dont-tempt-pimco-1432012296

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