Contingent convertibles, Prof Theo Vermaelen, Potash, shareholders and bondholders..

Happened to read a news article from Prof. Theo Vermaelen, about Contingent Convertibles. Firstly he defines these class of bonds as ones that are offered in financial crisis times by Banks(example Lloyds TSB) which are triggered once the capitalisation falls below a specified ratio say 5 %.Investopedia defines it as " A security similar to a traditional convertible bond in that there is a strike price (the cost of the stock when the bond converts into stock). What differs is that there is another price, even higher than the strike price, which the company's stock price must reach before an investor has the right to make that conversion"These bonds are nicely suited for bond holders who can exit at the same price of their investment.
(A video of Prof. Theo is available at http://www.cnbc.com/id/15840232/?video=1540724090&play=1)Basically it is call option that converts bonds into stock(or fresh equity) after breaching a specific trigger. This is specially useful in case of risky assets such as Bank capital adequacy ratios.If the capital fall below 5 % then bonds can be converted into stock and the capital can reach to 7%(just an simple example). Of course there is an incentive for bondholders to convert into shares, they receive more shares than the corresponding buying power of the bonds as in the normal times(as against in times of distress)
In their new paper Vermaelan and others propose a new security, the Call Option Enhanced Reverse Convertible (COERC). The security is a form of contingent capital, i.e. a bond that converts into equity when the market value of equity relative to debt falls below a certain trigger. The conversion price is set significantly below the trigger price and, at the same time, equity holders have the option to buy back the shares from the bondholders at the conversion price. Compared to other forms of contingent capital proposed in the literature, the COERC is less risky in a world where bank assets can experience sudden jumps. Moreover, the structure eliminates concerns about putting the company in a "death spiral" as a result of manipulation or panic. A bank that issues COERCs also has a smaller incentive to choose investments that are subject to large losses.
All this points out to a tricky territory for the investors. Also the strategies proposed above seem to be significantly tilted towards reducing the "areas of conflict" between bondholders and shareholders" Worth mentioning here is the pecking order theory at the time of financial distress. Also COERC and other Contingency convertibles offer companies an option to save themselves from financial distress by recapitalising through swapping of equity among two(main) principals .i.e. shareholders and bondholders.
Potash is not going down under to BHP, as of yet. The offer price of 130 a share was deemed too low by the board and they expect at least 160 offer to emerge from BHP. Analyst expect BHP to come up with a revised offer. Looks to be a another big acquisition story which will keep finance watchers on the hooks....


Link to the COERC article is here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1656994

The commodities market, issue and MY project on commodities....

GRAPH showing change in US wheat prices.

This week the biggest topic in the commodities market is the escalating price of wheat.BHP Billitons bid for potash has shown their agriculture related ambitions. Sounds as a foray into agriculture, but looks related to core business since some of the raw materials used in agro fertilizer is mined as well. The adjoining figure shows the fluctuations in the wheat prices. The commodities market is indeed a complex market with lots of data related to price volatility, fluctuations, long term and short contracts and the different expectations of sellers and buyers with respect to the prices of their produce.
Fortunately since I have been working on a project that analyses the agricultural marketing system in India, it has offered me insights into the pricing issues related to commodities. I will discuss more on this in coming days.

Selected News, bond yields, deflation and economy ...

Happened to read an article from a columnist in FT yesterday, It was about the negative returns for the US Treasury Inflation Protected securities,(TIPS). The whole point was who would be buying securities that are protected for inflations with negative "real" returns. A standard definition of TIPS would give this:
" TIPS are bonds issued by the US Government that guaranty you a fixed return (usually around 2%) PLUS whatever inflation (CPI) turns out to be each year. These bonds are one of the safest investments you can make because there is very little or no credit risk (issued by the US government), liquidity risk (TIPS are heavily traded), or inflation risk. These TIPS bonds adjust their principal value and payout twice a year to compensate for any inflation"
Along with this, the few of virtues of buys TIPS, include protection from inflation, and deflation, along with offering real yield diversification. But is this a real problem for investors? I think it is. the simple explanation for this is the fallacy involved in selling the TIPS. Even though inflation protected securities are marketed and widely seen as a tool against adverse inflation movements(from the point of hedging the inflation risk), it actually offers pretty much less fortification against deflation. Maybe this quote can explain it in a better way.
"Deflation remains a larger risk as long as interest rates remain near zero, the firm said. Although investors in conventional Treasuries are "protected" by the zero bound on nominal yields, investors in TIPS are exposed to a bit more risk due to the cash flows of such bonds declining in tune with deflation."
So the risk associated with TIPS isn't exactly related to deflation but rather sublimed due to the declining cash flows.
The events triggered by the TIPS saga has precipitated the movement of banks towards mortgage bonds over Treasuries for the prospect of higher yields.

I was thinking to write something about the economy this week, but it(the news) is full of usual stuff, Job losses, fears of deflation, and so on. I would prefer not to discuss the job losses figures, especially at a time, when I am hunting for a job!