Are CoCo Bonds about to ‘pops’?

Contingent convertible bond, or known as CoCo (not the cereal), is an important financial instrument in the financial industry which the regulators highly promote. Unlike the regular convertible bond, CoCo bonds attract a much higher attention especially during and after the banking crisis (particular with Deutsche Bank’s current situation) due to its uniqueness and the important role it plays. Bank of International Settlement defines CoCo bonds as Hybrid Capital Securities that absorb losses when the capital of the issuing bank falls below a certain level. Convertible bonds, on the other hand, allows the bondholders (not the obligation) to convert their bonds at specified date into equity (at a conversion rate). You can consider one is converting in ‘life-threatening’ situations whereas one is voluntary (you probably can figure out which is which).

To prevent banking crisis, capital adequacy is one of the key measures to enhance the survival ability of the banks. Having a higher capital will allow banks to increase the capacity to absorb potential losses to remain solvent. Due to the increased risk, expected return on CoCos is said to be between 5% to 7% whereas high yield bonds are offering 4% (Source: BAML and Credit Suisse). The chart below also shows the CoCo bonds offer four times the spread relative to the senior bonds which reflects its high riskiness.

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How do CoCo Bonds work?
“Like teenagers, they spend many hours in their bedrooms, suspiciously quiet, you never knowing what they are up to and then suddenly there’s an outburst of sound and fury, the cause of which you never understand.” Paul Wilmott (Researcher in Quantitative Finance)

CoCo Bonds tend to convert into equity thus diluting the existing shareholding once there are triggering events (such as capital ratio shortfall). The conversion of CoCo Bonds has two elements (Trigger and Loss Absorption Mechanism).

The trigger breaks into two; one is mechanical, and the other is discretionary. With mechanical trigger, the terms and conditions for the trigger were specified in the bond documentation (usually, the trigger is based on certain capital ratios (CET1 for instance)). The capital measure can be based on book values (accounting-based) or market values. Book values tend to look at CET1 as a ratio of risk-weighted assets and are limited by the reporting frequency and the differences in internal risk models across different banks. Market values could be complemented because of its readily available data used to assess the ratio of market capitalization to the assets which reduce the likelihood of financial statement manipulation. Discretionary, also known as the point of non-viability (PONV), is more of a regulator’s judgement of the bank’s solvency outlook.

Loss Absorption Mechanism comes in two forms, conversion to equity (fixed or variable) or principal write-down (complete, partial, permanent and temporary). Each of these will lead to different payoffs. Hence the investment managers will assess the implications and the recovery rate to determine the risk-reward profile of the CoCo Bonds.

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Depending on the trigger level, there are two CoCo groups:
1) ‘Going-concern’ CoCos which usually set the triggering level at 7% to 8%. It restores the capital position (through conversion or principal write-down) well in advance of the Point of Non-Viability. However, the financial institutions are still considered as ‘going-concern’ or solvent.

2) ‘Gone-concern’ CoCos usually set the triggering level at 5% which without the loss-absorption mechanism, is deem as not ‘going-concern’ hence the name ‘gone-concern’.

The higher trigger level, suggests a lower probability of being converted (relative to the lower trigger level). It is an important consideration from the credit risk perspective as evident by the lower credit rating (holding everything constant).

The Key Drivers for the Popular Usage of CoCo Bonds
1) To meet the capital requirements – an essential function of this hybrid capital instrument is to allow the banks to have the flexibility to convert debts into equity (essentially changing the capital structure to ensure there is higher loss absorption ability. To reduce the reliance of taxpayers money to bail out banks).

2) Equity market reluctant to provide equity capital – vulnerability of the banking industry, too big to fail and many other considerations, investors are more cautious with providing capital.

3) Flexibility – at the time of distress, raising capital to strengthen the balance sheet may not be possible due to negative sentiment, time and costs involved. CoCo bonds provide flexibility to convert into equity when certain conditions are satisfied.

4) Tax-deductibility – being able to enjoy the equity feature while retaining the tax-deductibility feature in its capital structure is highly attractive to the banks.

5) High-Risk equals? – High return, of course. To meet the demand of the institutional and private investors, higher return that high yield bonds may attract certain investors. Investors chasing for yield will be attracted to invest in these bonds.

Banks are operated in a highly leveraged environment, and their underlying business model is all about leverage hence capital requirements will ensure the banks have sufficient capital to weather the storm (has sufficient cushion to absorb losses).

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The figure from IMF showing the target yield of different types of investors.

Where do CoCos sit within the Capital Structure?
There are three types of capital in the banks:

CET1 (Common Equity Tier 1) Primarily comprises of share capital, retained earnings and other reserves. Mostly, you can view this as the equity capital. It is at the bottom of the capital structure and first to absorb the losses.
AT1 (Additional Tier 1) Hybrid capital instruments that comprise items such as preferred shares and convertible securities.
Tier 2 Revaluation reserves, hybrid instruments, subordinated term loans, share premium resulting from the issuance of Additional Tier 2 Capital, certain loan loss provisions, etc. You may consider it as less reliable than tier 1.

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For ‘Systematically Important Financial Institutions”, they have to hold additional capital to increase its resiliency in times of financial distress (we will cover Systematically Important Financial Institutions in the future). The charts are from Credit Suisse which is as of August 2014. (We will not look into the details of the RWA and the capital ratios).

There are two types of CoCo Bonds (AT1 CoCos and Tier 2 CoCos), and as the name suggests, we do not need to discuss the seniority of these CoCos. The point to note is that Tier 2 CoCos’ coupons cannot be suspended whereas AT1 CoCos’ coupons can be suspended once triggered. And there is no fixed maturity for AT1 CoCos. Now you could see why it ranks differently due to different characteristics
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The market of CoCo Bonds

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The market is huge and is growing exponentially, mainly attributable to lower yield on safer investments which resulted in investors’ hunger for higher yield instruments and to satisfy the regulators (shifting the risk taking to the capital market).

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The asset managers and hedge fund play a significant role in these CoCo markets (source: Becker Friedman Institute).

Are CoCo Bonds as good as they promised?
For stress testing purposes, CoCo Bonds are a cheap method to enhance the capital ratio
, and their costs are much lower than the equity capital. Despite its benefits discussed, there is rarely win-win situation in financial instruments and bound to have some limitations.

The complexity of the CoCo Bonds is a significant risk to the financial markets as the market might not fully understand or has the expertise to analyse the instruments. Financial Stability Report by the BOE warned that “investors were placing insufficient weight on the likelihood of a conversion is being triggered”. Potentially burning the investors’ savings and pensions.

Death-Spiral is another issue with the CoCo Bonds. CoCo Bonds promote share price drop because the bonds will be converted into equity (diluting the existing shares). In addition to that, to manage the risk, bondholders can short sell the shares in anticipation of potential conversions. The surge in short-selling interests, in turns, send an adverse signal to the market, sending the share price off the cliff. When the market overreacts or acts irrationally, it will lead to unnecessary volatility in the capital market. The contagion effects could be enormous and may lead to another crisis.

CoCo Bonds, to a certain extent, definitely shifts a significant amount of risks from taxpayers and banks to the capital markets. The cushion of CoCo Bonds does not address the core issues in the banking industry. As the Alberto Gallo (Head of Macro-Credit Research at RBS) said, “holding an extra parachute will not help if you do not know how to open it before the jump”.

Summary
Every financial instrument is a double-edged sword and needs to be
handled with care. Despite its loss absorption function, banks and regulators might be reluctant to trigger and convert the bonds into equity or write-off (avoid sending adverse signals and contagion effect). As CoCo Bonds exhibit both debt and equity characteristics, the valuation is often complicated and require advanced financial models to assess the risk and return profiles. CoCo Bonds do not have high coverage in the textbook world, and we hope that it will give a better insight what CoCo Bonds are and the key risks, considerations and the role it plays in the capital market.

Contributor: Jackson Yuen

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