The Securities Litigation Expert Blog

Leveraged and Inverse ETFs - Tracking Error

Posted by Jack Duval

Mar 12, 2018 8:07:34 AM

This blog post continues a series exploring leveraged and inverse ETFs.  Our previous posts can be read here and here.

February was a volatile month for the S&P 500.  Leveraged and inverse ETFs that track the S&P 500 saw volatility commensurate with their leverage.  However, compared to their un-leveraged peers, the major leveraged and inverse ETFs did not track the market closely.

Because of the constant leverage trap, we know that leveraged and inverse ETFs are forced to buy high and sell low on a daily basis.  This, plus the management fees of the funds, essentially lock in losses.

On a day to day basis, these factors are de minimis.  Over time, they are fatal.

Table 1: Leveraged and Inverse ETF Performance - February 2018

Screen Shot 2018-03-12 at 7.44.04 AM.png

Source: Bloomberg

As can be seen in Table 1, all the ETFs underperformed.  The underperformance increased with leverage and being directionally wrong.

As with all investments, volatility hurts returns.  For investors in leveraged and inverse ETFs, volatility leads to significant underperformance even over short holding periods.

Because of this complexity risk, these products are only suitable for sophisticated investors wishing to speculate by day trading or for one-day holding periods.

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Topics: suitability, Leveraged and Inverse ETF, Complexity Risk, Tracking Error

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

Volatility-Linked Products - Bank of America Strategic Return Notes

Posted by Jack Duval

Dec 1, 2017 10:07:27 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In this post, I examine the Bank of America Strategic Return Notes Linked to the Investable Volatility Index (“SRNs”), which were issued on November 23, 2010 and matured on November 27, 2015.

The SRNs were supposed to offer investors exposure to a volatility index over a five-year period.  However, due to high upfront and ongoing annual fees and the negative roll yield (previously discussed here and here), the investment resulted in almost a complete loss.

What is remarkable is that anyone who understood volatility products and negative roll yield would have known this ex-ante, that is, before the product was brought to market.  This is an example of how complexity risk manifests itself in investments, the people who created the investment didn’t understand it.

Disclosures, Negative Roll Yield, and Principal Destruction

The SRN Pricing Supplement lists the two percent upfront fee and the 0.75% annual internal fee as costs but does not mention the negative roll yield as a cost.  This is remarkable given that the negative roll yield is the primary cost of the strategy as it was to be implemented.

There was one disclosure in the SRN Pricing Supplement (on page 14) which addressed the negative roll yield (however, the phrase “negative roll yield” was not used):[1]

If the level of forward implied volatility is higher in the more distant S&P 500 Index options expirations months than it is in the nearer expiration months, then the level of the Index could be adversely affected as the Index positions are rebalanced daily to maintain a constant maturity.  The rebalancing involves increasing exposure to more distant forward implied volatility and decreasing exposure to more near-term forward implied volatility which may decrease the payment you receive at maturity or upon exchange.  Historically, the more distant expiration months have typically had a higher level of forward implied volatility than the nearer expiration months.

This explanation does not make it clear that the negative roll yield will be an almost certain daily destroyer of the investor’s principal.  Given the five-year term of the investment, the negative roll yield, coupled with the two percent up-front fee, and the 0.75% annual internal fee are virtually guaranteed to result in a catastrophic loss to the investor.

Of course, that is what happened.  The SRN’s were issued at $10/share and matured at $0.50/share.[2]  A 95 percent loss.  The negative roll yield was costing between four and 12 percent per quarter in 2011.[3]

Complexity Risk

This is a classic example of complexity risk, which I have written about extensively here and here.  Merrill Lynch broker Glen Ringwall was quoted saying:[4]

The roll costs are far larger than we ever understood or were disclosed to us…  This is borderline crooked.

To Mr. Ringwall’s point, if we assume that the negative roll yield was four percent per quarter that equals 16 percent per year.  Apply that over the five-year term of the SRNs and you get an 80 percent decline in principal.  Add the 5.6 percent total term costs from the front-end load and the ongoing management fees and the SRN is programmed to decline by 85.6 percent over its lifetime (assuming no movement in the underlying index).  Put another way, the underlying index would need to have and 85.6 percent return just to break even.

It is hard to believe that anyone associated with the SRNs creation understood these economics.  It appears that the brokers who sold it certainly did not understand.  And I can assure you that not one client who was sold the SRNs understood them.

DIY Client Due Diligence

In fairness, the SRN Annex to the Pricing Supplement did provide these user-friendly explanations what would help clients understand how to calculate the negative roll yield themselves:[5]


Screen Shot 2017-12-01 at 8.16.17 AM.png

Screen Shot 2017-12-01 at 8.16.29 AM.png

Screen Shot 2017-12-01 at 8.16.45 AM.png

Obviously, no client is working through these equations.

The written and formula disclosures above illustrate the primary point of investment complexity risk:  the more complex an investment is, the more likely it is to behave in ways that are unexpected.

This is the reason why complexity should generally be avoided and even sophisticated institutional investors should have a complexity risk budget to track and limit their exposures.


As I have discussed in my previous posts, there are other volatility products such as the iPath VXX ETN trading today that have the same internal negative roll yield dynamics.

Supervisors must be knowledgeable about these investments and how they are not meant to be held longer than one day.  Supervisory policies and procedures should be implemented to insure that any holding periods longer than one day are flagged in exception reports and remedied immediately.



[1]       Strategic Return Notes Pricing Supplement; PS-14.

[2]       Jean Eaglesham, The Wall Street Journal; SEC Readies Case Against Merrill Lynch Over Notes That Lost 95%; Available at:; Accessed December 1, 2017.

[3]       Id.

[4]       Id.

[5]       Strategic Return Notes Pricing Supplement; Annex A; A1-2.  I have only produced part of them here.

For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products, negative roll yield

Volatility-Linked Products - Death By a Thousand Cuts

Posted by Jack Duval

Oct 25, 2017 9:11:58 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In my previous blog post, I discussed how volatility-linked ETPs are likely to lead to significant, if not catastrophic, losses if they are used in a buy-and-hold strategy.

In this post, I want to explain the mechanics of how this process works.

Constant Maturity

Most volatility-linked ETPs must, by prospectus, maintain a constant maturity.  For instance, the VXX pricing supplement states:[1]

(The VXX) is linked to the performance of the S&P 500 VIX Short-Term Futures Index TR that is calculated based on the strategy of continuously owning a rolling portfolio of one-month and two-month VIX futures to target a constant weighted average futures maturity of 1 month.

In order to keep the weighted average futures maturity of one month, the two contracts will have to be adjusted on a daily basis.  This necessarily implies buying more of the two-month VIX futures and selling the one-month VIX futures.

Having to keep buying longer dated futures and selling shorter dated futures is what creates losses over time.


Contango is a term describing the typical futures market curve where longer dated contracts are more expensive than shorter dated contracts, all else being equal.  (The opposite of this is known as “backwardation”, and is rare.)

The VXX pricing supplement describes contango as follows:[2]

… many of the contracts included in the Indices have historically traded in “contango” markets.  Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months.  VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to “roll” the futures.  The existence of contango in the futures markets could result in negative “roll yields”, which could adversely affect the value of the Index underlying your ETNs and, accordingly, decrease the payment you receive at maturity or upon redemption.  (Emphasis added)

Chart 1: VIX Futures Curve[3]

 VIX Volatility Chart.gif


Negative Roll Yield

In plain English, by continuously buying longer-term VIX contracts and selling shorter-term VIX contracts the VXX ETN is buying high and selling low every day.  This phenomenon is known as “negative roll yield”.

It is a mathematical certainty that negative roll yield will erode the value of any investment that maintains a constant maturity such as the VXX.  As discussed in my previous post, the longer volatility-linked ETPs are held, the longer their holders are subjected to negative roll yield.

This results in a death by a thousand cuts, one each day.  The certainty of negative roll yield over time is why constant maturity volatility-linked ETPs all head towards zero.  Due to Zeno’s paradox and the magic of reverse splits, they never reach zero.  However, that is cold comfort for anyone who has lost 99.9 percent of their investment.


The supervisors of any firm allowing their advisors to trade in volatility-linked ETPs should be well versed in the mechanics of these products.  Clients certainly don't understand these complex products and frequently their advisors do not either.  Their suitability is limited to trading clients who want to speculate on intra-day or one-day changes in the VIX index, and they are unsuitable for a buy-and-hold strategy.

Furthermore, supervisory systems should flag any volatility-linked positions held more than a day.



[1]       Barclays iPath S&P 500 VIX Short-Term Futures ETN pricing supplement; July 18, 2018; Available at:;  Accessed October 25, 2017; PS-1.

[2]       Id. at PS-13.

[3]       VIX Volatility Curve; Bloomberg; Accessed October 25, 2017.

For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products

Volatility-Linked Exchange-Traded Products

Posted by Jack Duval

Oct 20, 2017 8:04:35 AM

This blog post begins a series exploring volatility-linked exchange-traded products.

VXX LT Chart.gif

The VXX has declined from 11,940 to 34.39 (split adjusted).  Source: Bloomberg.

A recent FINRA Acceptance, Waiver, and Consent (“AWC”), with Wells Fargo and the issuance of FINRA RN 17-32, highlights the risks of volatility-linked exchange-traded products (“ETPs”).  In particular, using them as part of a buy-and-hold strategy is virtually certain to produce losses.

Wells Fargo AWC

On October 16, 2017, FINRA ordered Wells Fargo to pay $3.4 million in restitution to clients who had been recommended volatility-linked exchange-traded products.  FINRA found that Wells Fargo registered representatives had sold the volatility-linked ETPs without fully understanding their risks and features and that the firm had failed to supervise solicited sales of the products.

The FINRA AWC press release stated:[1]

Certain Wells Fargo representatives mistakenly believed that the products could be used as a long-term hedge on their customers’ equity positions in the event of a market downturn.  In fact, volatility-linked ETPs are generally short-term trading products that degrade significantly over time and should not be used as part of a long-term buy-and-hold investment strategy.

FINRA RN 17-32 – Volatility-Linked Exchange Traded Products

The language in the Wells Fargo AWC press release is echoed in FINRA RN 17-32:[2]

… many volatility-linked ETPs are highly likely to lose value over time.  Accordingly, volatility-linked ETPs may be unsuitable for certain retail investors, particularly those who plan to use them as traditional buy-and-hold investments.


Using a buy-and-hold strategy with volatility-linked products is almost guaranteed to produce losses for investors.  These products are designed to be traded intra-day or over one day holding periods.  Even relatively short-term holding periods of a week or two can be enough to lock in losses.  Longer holding periods can produce catastrophic losses.

How these losses are built into the structure of volatility-linked ETPs will be explored in my next post.



[1]       FINRA News Release; Available at:; Accessed October 19, 2017.

[2]       FINRA RN 17-32; Volatility-Linked Exchange-Traded Products; October 2017; Available at:; Accessed October 19, 2017; 1.

For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, volatility-linked products

Money Market Fund "Liquidity"

Posted by Jack Duval

Dec 22, 2016 8:16:00 AM

This blog post continues a series looking at liquidity in common investments such as ETFs and mutual funds.  See previous posts on high yield and the Third Avenue Focused Credit Fund.

Greek Bank Run.jpg

Bank run at the National Bank of Greece                                 


As the banks and brokers/dealers have reduced their risk appetites (and balance sheets devoted to market making/inventory) liquidity has shifted to investment funds.

This shift has occurred during a globally coordinated central bank easing/asset purchase cycle heretofore unknown in financial history.  Liquidity has not been needed because all assets (with the exception of volatility) have risen in price.

When asset prices fall, liquidity will be needed again.  With the banks and broker/dealers less willing to buy, liquidity will be at a premium.  It will be a buyers market and prices will have to fall further to entice liquidity back into the markets.

As will be explored, the potential for suspended redemptions is very real, often in places where investors least expect it.

Money Market Funds - Your Money is Safe with Us (from you)

Most investors would be surprised to learn that their money market fund has a "gate" just like a hedge fund.  Yet that is the case with the vast majority of money market funds.  In addition to a gate, most money market funds also have the ability to charge a one or two percent fee for investors to redeem their shares, if certain conditions are met.

Vanguard Prime Money Market Fund

The Vanuard Prime Money Market Fund is the second largest in the world.  Here are some excerpts from the prospectus that might surprise its investors (emphasis added):

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Emergency circumstances. Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. In addition, Vanguard funds can suspend redemptions and/or postpone payments of redemption proceeds beyond seven calendar days at times when the NYSE is closed or during emergency circumstances, as determined by the SEC. In connection with a determination by the board of trustees, in accordance with Rule 22e-3 under the Investment Company Act of 1940, a money market fund may suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund. In addition, in accordance with Rule 2a-7 under the Investment Company Act of 1940, the board of trustees of a retail or institutional money market fund may implement liquidity fees and redemption gates if a retail or institutional money market fund's weekly liquid assets fall below established thresholds.

 Discretionary liquidity fee. The Fund may impose a liquidity fee of up to 2% on all redemptions in the event that the Fund’s weekly liquid assets fall below 30% of its total assets if the Board determines that it is in the best interest of the Fund. Once the Fund has restored its weekly liquidity asset to 30% of total assets, any liquidity fee must be suspended.

 Default liquidity fee. The Fund is required to impose a liquidity fee of 1% on all redemptions in the event that the Fund’s weekly liquid assets fall below 10% of its total assets unless the Fund’s Board determines that (1) the fee is not in the best interest of the Fund or (2) a lesser/higher fee (up to 2%) is in the best interest of the Fund.

 In addition to, or in lieu of, the liquidity fee, the Fund is permitted to implement temporarily a redemption gate (i.e., suspend redemptions) if the Fund’s weekly liquid assets fall below 30% of its total assets. The gate could remain in effect for no longer than 10 days in any 90-day period. Once the Fund has restored its weekly liquidity assets to 30% of total assets, the gate must be lifted.

I am not picking on Vanguard, every money market fund (with the exception of some government money market funds), has identical language in their prospectuses.

Suitability and Alternatives to Money Market Funds

In light of the liquidity risks to holding mutual funds, it is not suitable for investors to hold all of their cash equivalents in money market funds.  Instead, investors should hold three-month Treasury bills and just roll them four times a year.  They will have a lower yield than the money market funds, but this is trivial compared to a suspension of redemptions or a two percent haircut on the proceeds.


While the losses from a one or two percent redemption fee are limited, the secondary effects of preventing clients from making investments they otherwise could have made, will be considerable.


Supervisors at banks and broker-dealers should make sure their advisors are aware of the potential gates and liquidity fees and encourage diversification out of money market funds.

Complexity Risk

While money market funds have traditionally been less complex than other investments, the new regulations have changed that.  As we have discussed here, here, and here, investment complexity is a frequent destroyer of capital.

For money market funds, investors can be harmed by market events unrelated to the money market fund they hold.  For example, a Bloomberg stress test on the Vanguard Prime Money Market Fund shows that another Russian Financial Crisis would hit the fund's P&L for 1.32 percent.  This is enough to break the buck and/or require the fund to close the gate or implement liquidity fees.

Vanguard Prime MM - BBG Stress Test.gif

If you think this is an extreme event, consider that it is merely a "18-year storm".



 For information about securities expert Jack Duval, click here.


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Topics: suitability, supervision, Complex Investments, Complexity Risk, Money Market Funds, Liquidity

Warning: Contingent Convertible Bonds are Insurance

Posted by Jack Duval

Feb 16, 2016 8:06:02 AM

This post continues our series on insurance-liked securities ("ILS").

There has been a excessive amount of worry surrounding Deutsche Bank Contingent Convertible bonds ("CoCos") in the past week. (See our previous coverage here.)  As the weak sister in the European banking community, Deutsche Bank has been the focus of bond selling and consternation, as well it should be. The bank's stock is trading lower than during the Global Financial Crisis.

Chart 1: Deutsche Bank Stock Price Chart from 1999[1]


However, should anyone be surprised that Deutsche Bank's CoCo bonds have sold off? Absolutely not. Indeed, they have performed exactly as advertised.

So why the angst?

I believe it is another case of complexity risk. The CoCo bond structures are so complex that they have not been understood, even within the institutional investing community.

How could the sophisticated institutional investing community not understand a bond issuance? Days before the CoCo bond priced, Deutsche Bank issued a 44 page presentation to explain it's plans for strengthening it's balance sheet. I have extracted on page from that presentation below.

Chart 2: Deutsche Bank Explanation of "Comprehensively strengthening capital and leverage ratios for the longer-term"[2]


In order to understand this slide, you need to have facility with the following concepts:

Luckily, Deutsche Bank provided some footnotes to help investors understand at these regulatory items, for example:[3]

Global systemically important banks buffer may vary between 1% and 3.5%… DB currently assessed in the 2% bucket. Alternatively, a buffer for macro-prudential and /or systemic risk of up to 5% can be set by EU member states. The higher of the G-SIB buffer and this systemic risk buffer is then applicable... (the 2019 Requirements) currently excludes the potential for a countercyclical buffer of up to 2.5%… (the Adjusted Ratio) comprises fully loaded CET1, plus all current eligible AT1 outstanding (under phase-in).

Trying to figure out EU member bank capital requirements may have led to investors taking their eye off the bond prospectus. The Deutsche Bank CoCo bond prospectus disclosed a number of red flags that should have put investors on notice about the speculative nature of the debt. Some of those include:[4]

  • The bonds were rated below investment grade by S&P (BB), Moody's (Ba3), and Fitch (BB+) at issuance (P.1,7);
  • The interest payments are made (or not made) at the complete discretion of Deutsche Bank and "depend on the Issuers Available Distributable Items ("ADI")… ADI means: the profit at the end of the financial year... any profits carried forward... minus any losses carried forward, and any profits which are non-distributable pursuant to applicable law". (P.8) Thus, any hit to profits, whether from an economic slowdown, loan loses, or settlement/litigation costs from regulators or others, would put the interest payments in jeopardy;
  • Principal write-downs if Deutsche Bank's Tier 1 capital ratio fell to below 5.125% (P.11);
  • A reduction in liquidity of the Notes from any event that could result in a write-down (P.11);
  • Adverse price affects from changes in the Issuers Common Equity Tier 1 Capital Ratio (P.11);
  • No scheduled maturity date for the Notes and redemption at the sole discretion of the Issuer (P.11);

Insurance, not Bonds

Deutsche Bank's investors seem to be upset that the CoCo bonds have declined in value.[5] They should not be. CoCo bonds are a form of insurance-linked security. By purchasing them, the bond holders have chosen to insure the bank's Tier 1 capital ratio.

Once this is understood, it becomes obvious how the bonds should trade. The principal is not the bond holders, it is the "insurers" (bond holders) reserves. If the insured event comes to be (Tier 1 capital declining below 5.125 percent), the reserves go to the insured.

An insurer would be willing to make this bet in perpetuity (while adjusting premiums along the way for changes in risk). The fact that CoCo holders are now complaining about their returns shows that they are not willing to make this bet over and over and that they didn't understand it to begin with.

Chart 3: Deutsche Bank 3.7% of 24, CoCo, and Common Equity Price Chart[6]


It appears likely that the complexities of CoCos blinded buyers to the fact that they were entering the insurance business, and that they didn't know how to do proper underwriting.

CoCo bonds are only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation.  (These two criteria probably eliminate the vast majority of CoCo owners.)

As most investors learn at some point: the market is an expensive place to get an education.



[1]     Source: Bloomberg.

[2]     Deutsche Bank Investor Relations website; Available at:; Accessed February 15, 2016.

[3]     Id.

[4]     Deutsche Bank Undated Non-cumulative Fixed to Reset Rate Additional Tier 1 Notes of 2014 prospectus.

[5]     The Economist, Deutsche Bank's unappetising cocos, February 13, 2016; Available at:; Accessed February 16, 2016.

[6]     Source: Bloomberg.

 For information about insurance-linked securities expert Jack Duval, click here.


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Topics: suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

Litigation Costs May Sink Deutsche Bank Contingent Convertible Bonds

Posted by Jack Duval

Feb 9, 2016 7:48:07 AM

Guest Post by Len Santoro

Last year, European banks issued a record amount of a new type of high-risk bond meant to bolster each respective bank's Tier I capital in times of stress.  This year Deutsche Bank, which has been suffering through a lengthy restructuring and extreme litigation and settlement costs, may have to tap these bonds - wiping investors out.[1]

Deutsche Bank 6% Perpetual Contingent Convertible Bond Price Chart (Bloomberg)


These new bonds are called Contingent Convertible’s (“CoCo’s”).  They are a pre-funded source of capital meant to insure that the issuing bank maintains its Tier 1 Capital ratio if its other assets decline in value.

If a bank's assets suffer a catastrophic decline in value, the CoCo's are triggered and the capital gets transferred to the bank's balance sheet when it needs it the most, without having to go through a protracted and costly capital raise.

CoCo's can be considered a form of insurance-linked securities ("ILS") that insure against financial catastrophies (see our previous posts on ILS here and here).  CoCo's offer high yields, are highly complex, and can turn into equity or be written down to zero by the issuing banks at their discretion.

The creation and issuance of CoCo bonds goes back to the financial crisis of 2008-2009 which saw bank balance sheets destroyed by bad bets on sub-prime mortgages.  The international banking community, working through the Basel accords has been required to bolster its Tier 1 Capital.  CoCo bonds provide a buffer to an issuing bank's Tier 1 Capital.  Just like a catastrophe bond, if the issuing bank takes large losses to it's capital base, the CoCo bond gets written down for its owners and the assets are transfered to the issuer's balance sheet.

In this way, it can be thought of as insurance for the banks Tier 1 Capital ratio.

Tier 1 Capital

Tier 1 capital is comprised of common stock, retained earnings, some types of preferred stock, and certain hybrid securities such as trust preferred securities and now, CoCo’s.  It is used in the computation of a banks leverage ratio.  This ratio is calculated by dividing Tier 1 capital by total assets.

Since the global financial crisis, regulators have been working with banks to raise their Tier I capital (and thus lower their leverage).

Contingent Convertible as Tier I Capital

To qualify as Tier 1 capital, CoCo’s must meet a number of criteria, some of which include them being:

  • Unsecured;
  • Subordinated;
  • Not convertible at the holders option;
  • Having interest deferability where the profitability of the bank would not support payment.

Essentially, a CoCo is constructed to absorb losses when the bank's capital drops below certain regulatory levels.  Exactly how losses are absorbed varies by security and structure.

At issuance, CoCo’s are non-dilutive, debt servicing is subsidized by tax deductions, and, unlike traditional convertible securities, the issue is converted at the issuers discretion.  CoCo’s frequently do not have a maturity date and are typically callable every five years.  The other two key characteristics are the "trigger point" and the "lost absorption mechanism".

The Trigger Point

The trigger is the event that changes these securities from being contingent to certain.  Like ILS, CoCo triggers are very specific and are defined in the prospectus.  In practice, the trigger point is where the CoCo is partially or totally written down, or converted to stock.

Triggers can be formula- or regulatory-based and there are unique risks associated with each.  Formula-based triggers can be based on book or market value.  Book value triggers are less transparent and less timely.

Market value formula triggers have the advantage of being timely and transparent, however, they are subject to market pressures.

It's hard to imagine a situation where a trigger executed based on a regulator's decision would be preferred by the bondholder.

The Loss Absorption Mechanism

Loss absorption is simply the method through which management takes the bondholders investment.

There are two main methodologies for implementing this transfer of wealth.  One is through equity conversion and the other is through an outright principal write down of the bondholder's  investment.  Historically the loss absorption method has been evenly split between the two methods.

Equity Conversion

On the surface, equity conversion appears to be a preferential method for bondholders.  Having equity gives the bondholder some upside potential.  In addition, since equity conversion is dilutive, one can assume that management will be less motivated to implement the trigger.

However, the second part of the equity conversion method is the conversion price.  Depending on the issue, the conversion could be the market price at the time the trigger is breached or some other predetermined price.  Since a market price conversion would be dilutive, that is the most favorable to the CoCo investor.  A predetermined price conversion is less dilutive, and thus less attractive for bond investors.


Some CoCo's give the issuer the ability to write-down the bonds to zero if certain triggers are met.  In this way, they are similar to Catastrophe Bonds that have been issued by reinsurers to protect issuers against severe weather events. 

The principal write-down security is most attractive to the issuer since it is not dilutive to current shareholders.  As with most bonds, what is favored by the issuer should be avoided by the bond investor.  The danger of buying a principal write down CoCo with a "high " trigger is that the company can obtain cheap capital when the bank is still well above insolvency, all at the bondholder’s expense.

As a general rule, market price equity conversion with low triggers is most attractive while principal write-down with high triggers are the least.  As with all fixed income investments, the bondholder must recognize that they and management are adversaries.

If a Coco bond write down is executed at a relatively high trigger point, it could be a windfall for the stockholders.  In such a case, there would be a transfer of wealth from the bondholders to the stock holders when the bank is still far from insolvency.


CoCo’s have high complexity risk and are suitable only for the most sophisticated investors who are capable of understanding and evaluating their risks.  To fully evaluate the risks of a CoCo bond, an investor (or advisor) would need to understand at least the following factors:

  • Bank capital requirements and potential changes to those requirements;
  • The effect of the investment on an overall portfolio
  • Currency risks
  • The terms and provisions of the security
  • How economic and interest changes might affect the security

In the Deutsche Bank deal mentioned above, the prospectus states:[4]

The Notes may not be a suitable investment for all investors.  Potential investors must determine the suitability (either alone or with the help of a financial adviser) of an investment in the Notes in light of their own circumstances.  In particular, each potential investor should:
  • have sufficient knowledge and experience to make a meaningful evaluation of the Notes, the merits and risks of investing in the Notes...
  • have access to, and knowledge of, appropriate analytic tools to evaluate, in the context of his/her particular financial situation, an investment in the notes...
  • have sufficient financial resources and liquidity to bear all of the risks of an investment in the Notes, including the risk not to receive any return on investment or repayment of the invested amount...
  • understand thoroughly the terms of the Notes and be familiar with the behavior of the financial markets; and
  • be able to evaluate possible scenarios for econmic, interest rate and other factors that may affect his/her investment and his/her ability to bear the applicable risks.

Clearly, CoCo's are only appropriace for the most sophisticated market participants.  Furthermore, Deutsche Bank also attached a minimum lot size of the issue of $200,000, which demonstrates that it was not targeted for retail investors.[5]  (Most corporate bonds have $1,000 minimum lot sizes.)

In the current low interest rate environment, the mid-single digit percent yield on most CoCo’s is attractive[6].  However, chasing yield in CoCo bonds could end badly, especially for investors who did not understand what they were sold.

CoCo’s are only appropriate for investors who are comfortable speculating with their investments and who are prepared to see their CoCo investment wiped out if the bank issuers comes under stress.  As with all ILS, CoCo bonds should only be purchased in diversified pools and only represent a small portion of an investor’s diversified bond portfolio.



[1]      John Glover, "Deutsche Bank's Woes Threaten CoCo Coupons, CreditSights Says", Bloomberg.  Available at:; Accessed Tuesday, February 9, 2016.  For general background on CoCos, see:  John Glover, “Riskiest Bank Bond Sales Swell to Record in Europe”, Bloomberg, (October 1, 2014)

[2]           FDIC, “Optional Regulatory Capital Worksheet”,

[3]           Deutsche Bank Research, “Contingent Convertibles: Bank Bonds Take on a New Look”, May 23,2011,

[4]           Deutsche Bank 6% Perpetual Contingent Convertible prospectus, 8.

[5]        . at 5.

[6]           These yields are approximately three to four full percentage points over senior bank note bonds.

 For information about insurance-linked securities expert Jack Duval, click here.


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Topics: litigation, suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

Insurance-Linked Securities: Correlation in Hiding

Posted by Jack Duval

Nov 10, 2015 8:10:09 AM

For our introduction to Insurance-Linked Securities ("ILS"), see this.  In this post, I examine very likely ways in which ILS could be highly correlated with other assets.

Miami_Tornado                                                   An F-1 tornado hits downtown Miami on May 12, 1997.  Photo:  USA Today.


Insurance-linked securities are often touted as being non-correlated to traditional asset classes such as stocks and bonds. A recent research piece by Pioneer Investments listed the following 13-year correlations of ILS:[1]

  • U.S. Equities: 0.2;
  • Hedge Investments: 0.11;
  • Commodities: 0.2;
  • U.S. Aggregate Investment Grade Bonds: 0.19;
  • U.S. High Yield Bonds: 0.28.

Pioneer concluded:

One of the most appealing aspects of ILS is its potential diversification properties. By definition, performance is driven by random meteorological or geophysical catastrophic events, which leads to a very low correlation to traditional financial market investments… We believe including ILS within a broader asset allocation can have powerful diversification benefits and total return potential.[2] 

While this may be true much of the time, it will certainly not always be the case. ILS investments must be vetted very closely for potential connections to the buyer and the economy in general.


There are many scenarios in which ILS could be highly correlated to an investor’s total wealth[3] and for an institution, their other asset classes. I give examples of these correlations below.


Individual investors should not invest in ILS, nor pools of ILS, that insure perils they could experience themselves. An example would be a resident of South Florida owning ILS that insured risks such as: named storm, hurricane, wind, or water for South Florida. In such a scenario, the individual would be adding those risks to their portfolio when they were already exposed to them through their real estate holdings, businesses owned, and income steams.

This is a form of Company Town Risk, where many elements of an individual’s total wealth are connected to a common risk exposure. In our hypothetical scenario, the South Florida resident and business owner could have their total wealth wiped out by a category five hurricane that destroyed the individual’s office building and home. Their income would be stopped, they would be out of a home, and if they owned ILS with South Florida exposures, they could be severely haircut, if not entirely written down.

If the individual owned state or local municipal bonds, the impact could be even worse as their previously uncorrelated, safe, investments became correlated and unsafe at the worst time. 

If these scenarios seem far-fetched, consider Hurricane Patricia, which was the largest hurricane ever recorded in the western hemisphere. Patricia accelerated from a tropical storm into a category five hurricane in record time. Luckily, it made landfall near sparely-populated Manzanillo, Mexico, and then continued into the mountains of western Mexico where it quickly lost power.

Los Angeles is only about 1,700 miles north of Manzanillo and San Diego is closer. If Hurricane Patricia had made landfall in Los Angeles, it could have knocked out America’s biggest port for a month or more. The damage to Los Angeles and San Diego infrastructure could have been enormous. If airports, bridges and other utilities were shut down for prolonged periods, they would lack the revenue to meet debt payments.  This would certainly result in sharp markdowns to local and state municipal bonds as well as possible defaults.

The national economy could be negatively affected as well with a few points of GDP being shaved off due to bottlenecks and idled workers.


Institutional investors face similar issues. For instance, a large university in the south- or mid-west would have the same Company Town Risks described above. An F-5 tornado that hit a large metropolitan area where a university was located could cause high levels of property destruction and prolonged interruption of services.  The impact would likely be negative in a number of areas: university revenues would decline, as would the prices of any debt they had issued (raising the costs of financing), and any local ILS exposures would likely take an extreme, if not complete, write-down.

While there would almost certainly be insurance on university property, any ILS they owned would serve to limit those coverages. Indeed, an endowment that owned ILS that insured local tornado risks would merely be paying the university insurance proceeds from its own pockets.

In effect, the university would have paid for insurance coverage and then added the exact same risk back through the ILS.

This scenario holds true for all institutional investors, especially those running pensions or other asset pools for individuals in one geographically concentrated area.

Complexity Risk

ILS have a Byzantine complexity that only adds to their risk. Compounding this is the fact that most money managers are not insurance or underwriting experts. This implies that even the most sophisticated institutional investors will have to rely on third parties to vet and select ILS for them. Outsourcing understanding and due diligence is a risk that is uncompensated and frequently ends badly. Many institutional money managers discovered this the hard way after relying on the ratings agencies to understand and evaluate CDOs for them.  

As has been well documented, the rating agencies didn't know what they were doing, but the institutions took the loss.

I have discussed in a previously published white paper how investment complexity is a discrete risk factor. In subsequent posts I will discuss how complexity risk manifests itself in ILS and how they are only suitable in highly diversified investment vehicles, for very small percentages of a portfolio, and where a complete loss would be acceptable.



[1]      Insurance-Linked Securities: A Primer; Pioneer Investments; 2015; 4. Available at:;jsessionid=3469F67B1699177CBEDA86053B26AE10.atg01-prd-atg1?adtrack=ria_ils_pdf_primer; Accessed November 8, 2015.

[2]       Id. at 3-4.

[3]       For an explanation of Total Wealth, see our “Company Town Investing” white paper, available at:


For information about insurance-linked securities expert Jack Duval, click here.


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Topics: suitability, Complexity Risk, ILS, insurance-linked securities

Insurance-Linked Securities: Speculative with High Complexity Risk

Posted by Jack Duval

Oct 26, 2015 11:07:00 AM

This is the first blog post in a series exploring the risks and suitability of insurance-linked securities ("ILS") for retail and institutional investors.

Hurricane Patricia ILS Insured Peril              Hurricane Patricia as seen from space.  Photo: The Telegraph.

Insurance-linked Securities (“ILS”) are high yield debt instruments used to transfer specific risks from an insurance or reinsurance company to the debt holders.  In effect, they allow the debt holder to act as a reinsurer for the ILS issuer.  ILS are a significant development because they allow insurers to fund specific risks directly from the capital markets.

Some of the risks insured (called perils) include:

  • Hurricane/Wind
  • Earthquake
  • Severe Thunderstorm
  • Winter Storm
  • Cyclone
  • Typhoon
  • Volcanic Eruption
  • Meteoric Impact
  • Lottery Jackpot
  • Health Claims
  • Extreme Mortality

The most unique trait of ILS is that they usually have a binary payoff structure that hinges on a pre-defined trigger.  If the trigger is not reached, the ILS performs like a traditional bond, providing interest payments and then the return of principal at the maturity date.  If a trigger is reached, then the ILS performs like a bond from a distressed company.  Interest payments may be stopped and the principal amount paid back may be severely haircut or written down completely.

This binary payoff structure makes an ILS a speculative investment.[1]

Life Insurance Swap Example

The easiest way to understand ILS may be to think about them in terms that most people are familiar with, term life insurance.  Term life insurance policies can be thought of as very simple swap agreements.  The buyer of the policy pays a fixed rate payment every year for the term of the policy (let’s assume a 20 year fixed term policy).  The insurance carrier pays the policy owner a variable rate each year.  The determinant of the variable rate is whether or not the insured person is living.  If she is, the variable rate is zero, if she is not, the variable payment is the policy’s face value.

With ILS, the roles are reversed.  The insurance (or reinsurance) company becomes the buyer of the insurance and the ILS holder is the seller of the insurance.  The insurance company pays the fixed payment to the ILS holder (the premium payments, or interest) and receives back a variable payment determined by the occurrence of a trigger event.

Chart 1.  The Swap Structures of Term Life Insurance and ILS

 Term Life Insurance and ILS Deal Structure

Differences Between ILS and Traditional Bonds

The comparison of ILS and term life insurance is true in spirit, but leaves out one important detail, the existence of an intermediary between the ILS holder and the ILS issuer.  In the case of life insurance, the premium payments by the policy owner go into the insurance carrier’s general account where they are conservatively invested in order to meet future claims.

With ILS, the entire insured amount is held as collateral by a third-party trustee.  In effect, the insurance proceeds have been paid upfront and are being held in escrow.  If there is no triggering event, the proceeds revert back to the ILS holder, just like a typical bond returns the principal amount invested at maturity.  If there is a triggering event, the proceeds are delivered to the issuer (although sometimes after a delay of up to 36 months).

Collateralized Risk

Even though they are frequently called “bonds”, most ILS are not structured as typical fixed income securities.  A typical bond transaction is motivated by an entity that wants to raise money for its operations but does not want to sell an equity interest in itself.  In most cases, the entity will borrow money from lenders in exchange for interest at a specified rate and the promise to pay back the amount borrowed at a specified time.

The raison d’etre of a bond transaction is that the issuer will get the use of the proceeds until the bond matures, at which time the principal has to be repaid.  ILS do not work in this manner.  Indeed, in most cases, the issuer will never get the use of any of the proceeds.

Instead of going to the issuer, the proceeds from an ILS are usually held in a trust account and typically invested in risk-free assets such as U.S. Treasury bills or money market funds.

The issuer does make payments which flow through to the noteholders (as does the investment yield on the assets held in the trust account).  However, these payments are not interest payments as with traditional bonds.  They are insurance (or reinsurance) premium payments.

In this way, the buyer of an ILS is in effect an insurer.  If the insured event never happens, the insurance premiums are kept by the ILS buyer and no payments are made to the issuer of the ILS.  At the end of the contract term the principal held in trust is returned back to the ILS holders.  However, if an insured event trigger is reached, the premium payments can stop and the principal held in trust is (partially or completely) transferred to the issuer as a loss payment.  In this case, the note holders would receive back the remaining principal or nothing.[2]

This transaction structure is visualized below using the Everglades Re Ltd. Catastrophe Bond as an example.

Chart 2.  Everglades Re Ltd. Transaction Structure[3]

Everglades Re Ltd ILS Transaction Structure

ILS have a high degree of complexity risk, are speculative, and have a very real possibility of going to zero.  They should only be recommended (and purchased) in contemplation of a complete loss.



[1]                 “Speculative” is a term of art on Wall Street and is typically reserved for investments which have a high probability of becoming worthless.  Long stock options are a good example of speculative investments.  If they are out of the money at expiration (the stock is below the call price), they become worthless and the entire premium paid is lost.

[2]                 As will be discussed more below, it is not uncommon for the maturity date on many transactions to be extended by periods up to 36 months to allow for loss development and reporting.  These extensions do not apply to the risk period.

[3]                 Everglades Re Ltd deal structure was obtained from Standard & Poor’s RatingsDirect research.  Available at:; Accessed October 25, 2015.


For information about insurance-linked securities expert Jack Duval, click here.


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Topics: suitability, Complexity Risk, ILS, insurance-linked securities

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