Contingent Convertible Bonds

SPEAKER
ANSHUMAN PRASAD
Director, Risk and Analytics
CRISIL Global Research & Analytics

October 2013

© 2013 CRISIL Ltd. All rights reserved.

Contingent Convertible Bonds

Executive Summary
Rising Importance of CoCo Bonds
–
–

CoCo issuances have exceeded $20 billion in 2012 and 2013

–



CoCo bonds or contingent capital has taken off in a big way and can be considered a
new asset class

Past issuances have met with success, with oversubscription being the norm

CoCo bonds’ regulatory environment, features and valuation techniques are
in a flux and are still evolving
–

CRD IV directives, coming into force from January 1, 2014, envisage the use of
contingent capital as Additional Tier 1 capital

–

Industry is slowly moving to a certain standard: write-down feature, point of non-viability




(PONV) trigger, etc.
–

Valuation methodologies are evolving as academicians try to keep pace with the market!

–

Innovation in structures is still continuing (e.g., recent Swiss Re CatCoCo)

2

CoCo Bonds: An Overview (1/2)


What are Contingent Convertible Bonds?
CoCo bonds are hybrid capital securities that absorb losses in accordance with their
contractual terms when the capital of the issuing bank falls below a certain level

–

The first CoCo bonds were offered by Lloyds in November 2009, which exchanged
CoCos for its outstanding subordinated bonds

–

CoCo issuance volumes are rising and are expected to reach $1 trillion (S&P estimates)

Rising interest in CoCo Bonds
24.1

25

4.0 - UBS

20.7

3.7 – Soc Activos

7.0 - Credit
Suisse

USD Billions

20

16.3
15

11.7
10

16.3 - Lloyds
Banking
group

5

4.0 - Rabobank
2.3 -Allied Irish bk.

3.0
1.7 - Rabobank
1.3 - others

0
2009

3.5 – Banco do
Brasil

2010


–

4.0 – Banco do
Brasil

12.8 - others
9.7 - others

2.2 - Nomura
3.2 - others
2011

2012

2013

Source : Contingentconvertibles.com, CRISIL GR&A Analysis, as of Sep,16 2013

3

CoCo Bonds: An Overview (2/2)
Why were Coco Bonds introduced?
–

–

Can be used as regulatory capital under Additional Tier 1 and Tier 2 of Basel guidelines

–



As a bail-in mechanism to infuse additional capital under adverse market conditions
Transfer of risk from taxpayers to the private sector in times of distress

Factors Favoring CoCo Bonds
–

Regulatory support, especially in Europe as seen in CRD IV and FINMA (Switzerland)
guidance

–

Search for high-grade yield by investors

Banks and insurance companies that have issued CoCo bonds include:
Lloyds Bank

Rabobank

Credit Suisse

UBS

Barclays

Bank of Ireland

Swiss Re

KBC Bank

BBVA

Société Générale

Credit Agricole

Nomura

Macquarie Bank

Bank of Brazil




VTB Bank

4

CoCo Bond Structures
Types of CoCo Bonds
–

Contingent convertible bonds feature conversion into equity of the issuer in case the
trigger conditions are met at a pre-determined conversion price/ratio

–

Contingent bonds feature a write-down of the principal amount of the bonds upon the
occurrence of a specific trigger event

–

Principal write-down features are increasingly favored by regulators
Features of CoCo Bonds
Main design features of
CoCos

Trigger

Mechanical

Book-value
Source: Bank of International Settlements

or

and/or

and

Discretionary

Loss Absorption
Mechanism

Conversion to
Equity

or




Principal
Writedown

Marketvalue

1

5

Comparison of Features of CoCo Bonds Issued
Recent Issuances
–

Predominantly additional Tier 1 issuances with a discretionary trigger-based principal
write-down feature
Classification

Description

Example

By type of trigger event
Book Value/Accounting based

Core Tier 1 ratio falling below defined %

Barclays (2013)

Market Value/Market based

Share price/CDS spread linked

None

Discretionary Trigger

Triggered by national regulator

BBVA (2013), Barclays (2013)

Dual Trigger

Accounting + Discretionary Trigger

Credit Suisse (2010)

High-trigger CoCo

Additional Tier 1 capital

Société Générale (2013)

Low-trigger CoCo

Tier 2 capital

Nomura (2011), Bank of Ireland (2013)

Conversion into equity

Fixed number or value of shares

Lloyds bank (2009)

Principal write-down

Write-off of principal value




Rabobank (2010)

By level of the trigger

By Loss absorption mechanism

Source: Bank of International Settlements 1, CRISIL GR&A Analysis

6

Regulatory Treatment of CoCo Bonds
Tax Treatment of CoCo Bonds can be complex
–
–

If treated as equity, coupon payments may not be eligible for tax benefits, reducing their
attractiveness

–



Depending on the features, CoCo bonds can be treated as debt or equity for tax
purposes

Regional differences in tax treatment exist – eg., certain CoCos issued in response to
guidelines may be treated as equity, specifically in the US (Sundaresan & Wang, NY
Fed, Nov 2011)

Options for issuing CoCo Bonds
–

–



Regulation S (preferred by a majority of European issuers)

For US issuance, the predominant options include 3(a)(2) issuances /SEC registration




Treatment by National Prudential Regulation Authorities
–

Majority of issuers are currently European, but there are differences between Swiss
guidelines and CRD IV

–

As CoCos become an accepted instrument in a bank’s capital structure, the US may
also follow suit with further guidance (Report To Congress On Study Of Contingent
Capital, 2012)

7

European Treatment of CoCo Bonds
CRD IV was approved on April 16, 2013 and will come into force on January
1, 2014



Key features of CRD IV/EBA guidelines
–
–
–
–
–
–



Open Issues still to be addressed include:
–
–
–



CoCos or Buffer Convertible Capital Securities (BCCS) will be recognized as Additional
Tier 1 capital
BCCS need to be direct, unsecured, undated and subordinated
Trigger levels are set at 5.125% and 7%
Loss absorption features are either in terms of principal write-down or equity conversion
National regulator determined point of non-viability (PONV)
Coupon payments can be canceled at the discretion of issuer/national regulator




Further clarity on redemption incentives (e.g., call options or ability of investor to convert
into common equity)
Write-up provisions
Guidelines on the timing of the trigger event and write-down/conversion

BBVA Additional Tier 1 bonds, issued on April 29, 2013, were the first to
comply with CRD IV; they received a positive response
8

Swiss Contingent Capital Regulations


Swiss regulations allow low-and high-level triggers at 5% and 7%
Comparison of Swiss Proposals and Basel III Proposal

+
tbd
SIFI capital surcharge

6%
Low Level
Trigger CoCos

>13%
0% up to 2.5%
Countercyclical
Buffer

Basel III = 10.5%

3%
High Level
Trigger CoCos

2% Tier 2

Basel II = 8%

1.5% Other Qualifying
Tier 1 (OQT1)

4%
Tier 2

2% Other Qualifying
Tier 1 (OQT1)
2%

Common Equity
Tier 1 (CET1)

Basel II
Source: IMF Staff discussion note

+
5.5%
Common Equity
Tier 1


Swiss = 19%

2.5%
Capital Conservation
Buffer

4.5%
Common Equity
Tier 1

Basel III

4.5%
Common Equity
Tier 1

Switzerland

2

9

Key Considerations for Bond Issuers


Specific considerations for the CoCo Bond Issuers include:
Regulatory capital treatment: differences in treatment by national regulators

–

Tax considerations

–

Ratings considerations: S&P guidelines

–

Capital Structure considerations: Additional Tier 1 or Tier 2 dilution effects

–

Setting the triggers: High/low trigger


–

Performance of New issues
112
108
104
100
96
92
88
3-Apr-13

21-Apr-13

9-May-13

CREDIT SUISSE

27-May-13

14-Jun-13

UBS AG

2-Jul-13

20-Jul-13

7-Aug-13

BANCO BILBAO VIZCAYA ARG

25-Aug-13

12-Sep-13

30-Sep-13

BARCLAYS BANK PLC

Source: Bloomberg, CRISIL GR&A Analysis

10

Key Considerations for Bond Investors
Yield: Risk v/s Yield for various categories of investors



Rating: Certain categories would not be able to invest in unrated CoCo bonds



Tax Treatment: Debt or equity treatment



Equity Conversion or Write-Down: Certain fixed income investors are not able to invest in
convertibles to equity; on the other hand, full principal write-down increases risks

One-year performance of selected CoCos
115

Avg. Return: 5.8%
Avg. Sharpe Ratio: 1.4

110




105

100
95
Oct-12

Nov-12

Dec-12

Jan-13

Feb-13

Mar-13

Apr-13

May-13

Jun-13

Jul-13

MQGAU 10 1/4 06/20/57

LLOYDS 7 5/8 10/14/20
VTB 9 1/2 12/29/49

Sep-13

SRENVX 7 1/4 09/29/49

CS 7 1/8 03/22/22

Aug-13

RABOBK 6 7/8 03/19/20

Source: Bloomberg, CRISIL GR&A Analysis

11

Typical Investors in CoCo Bonds
Higher acceptance by private banks and retail investors followed by asset management firms

 Attractive yields are drawing investors; yields are, on average, 3-5 percentage points higher than other
non-CoCo subordinated debt and senior unsecured debt of the same issuer
 However, the response to recent issuances was not as favorable as in the past (e.g., SocGen)

 Reg S issuances by European banks have received a favorable response
 Demand from asset management firms is also picking up

Lower adoption by hedge funds, banks and insurance firms


 Europe and Asia-based private investors and private banks are the key target

 Till recently, CoCo bonds were unrated

 Ratings are five notches below senior unsecured debt of same issuer
 Banks holding CoCo bonds directly increase systemic risks
 Correlated with business cycles — no significant diversification benefits to the portfolio
 Regulatory treatment not yet clear in many jurisdictions

12

Valuation of CoCo Bonds (1/2)
Design of a Valuation Model for a CoCo Bond is driven by:
 Modeling the underlying trigger
Capital Ratio, Market Price, CDS Spreads, Discretionary, Multivariate

 Additional Features
Callability
The Payoff Structure of a CoCo Bond is quite different from that of a Convertible Bond
100
80

Limited downside,
unlimited upside


 Value of CoCo at conversion
Fixed Value Conversion, Fixed Number Conversion, Principal Write-off

P

60
40

Unlimited downside,
limited upside

20
0
S

S
Convertible

CoCo

Bond Floor

Parity

Source : Spiegeleer and Wim Schoutens 4

13

Valuation of CoCo Bonds (2/2)

 In the industry, a variety of tree-based simulation approaches are used for pricing these instruments,
mainly using CDS spreads and/or ratings for calibration
 Modeling approaches proposed in academic literature have included:
Equity and Credit Derivatives Modeling approaches (under Black Scholes); Jan De Spiegeleer, Wim
Schoutens (2011). A later paper extends these approaches under Smile conform models
Structural modeling approach; George Pennachhi (2011), Markus P.H. Buergi (2012)
Determinants of a Contingent Convertible's Value
Probability of Conversion
Value of Equity Part

Value of Bond Part
Trigger Underlying

Trigger Level

Maturity
Coupon Rate

Nominal
Amount
Source : Markus P.H. Buergi

Risk
-free
Rate

Conversion
Fraction


Pricing Approaches

Conversion
Ratio
Stock
Price
at
Conv.

3

14

Modeling Limitations and Challenges


Valuing CoCo Bonds is challenging because of many reasons, including:
–

Lack of clarity on point of non-viability (PONV) regulatory triggers
• Trigger is discretionary by design

–

Challenges in linking market observable parameters to pricing

–

Market size, liquidity and number of issuers
• Lack of data points

–

Frequency of data reported
• Infrequent updating of data (e.g., accounting ratios and credit ratings)

–

Wide variation in features
• Quite a lot of combinations are possible in product features, making every CoCo issuance unique
in some respects




• E.g., Share prices and CDS spreads

Newer models are being developed in the industry and in academia to tackle
these challenges
–

Given the rising importance of CoCos and their effect on the banking system, it would be
good to have a variety of models available for proper model benchmarking

15

Assessing Risks
Market Breadth and Depth

Many major investor classes do not yet invest in CoCos because of
the taxation issues involved, security classification and lower ratings

The occurrence of the trigger event itself has a negative signaling
effect, causing unwanted pain to the issuer
Rollover Risks
CoCos are less effective near maturity
Manipulation Risk
Investors could make a manipulative attack to cause a trigger event to
their benefit


Adverse News Causing Trigger

Effectiveness in Systemic Crisis

Diversification of systemic risk might not happen if CoCo bond holders
themselves are systemically important
Pricing Risks
Pricing is model dependent and is based on assumptions

16

References
1. Stefan Avdjiev, Anastasia Kartasheva, Bilyana Bogdanova 1 (2013), CoCos: a primer, BIS Quarterly Review, September 2013
2. Ceyla Pazarbasioglu, Jianping Zhou, Vanessa Le Leslé, Michael Moore 2 (2011), Contingent Capital: Economic Rationale and Design Features,
IMF Staff Discussion Note, January 25, 2011

3. Markus P.H. Buergi 3 (2012), A tough nut to crack: On the pricing of capital ratio triggered contingent convertibles, Department of Banking and
Finance, University of Zurich, March 12, 2012

5. Stability Oversight Council (2012), Report To Congress On Study Of A Contingent Capital Requirement For Certain Nonbank Financial Companies
And Bank Holding Companies.
6. Sascha Wilkens, Nastja Bethke (2013), Contingent Convertible (“CoCo”) Bonds: A First Empirical Assessment of Selected Pricing Models, 9th
August 2013.
7. George Pennacchi (2010), A Structural Model of Contingent Bank Capital – Working paper , Federal Reserve Bank of Cleaveland
8. Wilson Ervin (2011), A new pull for CoCos, risk.net/risk-magazine, August 2011

9. Francesca Di Girolamo, Francesca Campolongo, Jan De Spiegeleer, Wim Schoutens (2012), Contingent Conversion Convertible Bond: New
avenue to raise bank capital


4. Jan De Spiegeleer, Wim Schoutens 4 (2011), Pricing Contingent Convertibles: A Derivatives Approach, Katholieke Universiteit Leuven, March 18,
2011 Financial

10. HM Treasury (2012), Banking reform: delivering stability and supporting a sustainable economy
11. Suresh Sundaresan, Zhenyu Wang (2011), On the Design of Contingent Capital with Market Trigger, Federal Reserve Bank of New York Staff
Reports, no. 448, November 2011

12. Basel Committee on Banking Supervision (2011), Basel III: A global regulatory framework for more resilient banks and banking systems, Bank for
International Settlements, June 2011

17


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Annexure 1: Credit Derivatives Approach
Model Intuition


The main feature of a CoCo bond is conversion in case of financial distress of the company. The credit spread is therefore
closely related to computing the survival probability and recovery rate



Credit Spread,



Here, Recovery Rate = Stock Price Initial/Conversion Price



LambdaTrigger is the default intensity and is related to the Survival Probability

LambdaTrigger

Survival Probability = exp ( - LambdaTrigger



The accounting or regulatory trigger is assumed to be related to a trigger on the share price



Finally, in a Black-Scholes environment, one can get the survival probability, which is dependent on the dividend yield,
interest rate, volatility, maturity and current share price


Modeling Methodology

Limitations of the Model


Does not incorporate the non-negligible stream of future coupon payments that the holder of the CoCo bond forfeits at
conversion. Quite important as it could result in CScoco = 0, in certain cases



The method does not result in a unique implied trigger level. This results in different trigger levels for similar CoCo bonds
issued by the same issuer with varying coupons

Source: Spiegeleer and Wim Schoutens (2011) 4

19

Annexure 2: Equity Derivatives Model
Model Intuition


The payoff structure of a CoCo bond is replicated by a combination of different instruments
CoCo Bond = Zero Coupon Corporate Bond + Knock in Forward(s) -



The knock-in forward represents the trigger event, at which the CoCo bond holder exchanges the bond against shares at a
pre-determined strike price



The binary down-and-in options reflect the cancellation of the coupon payments after the conversion has taken place



Model Inputs
Stock price, Dividend yield and Implied volatility of embedded options — all market observable



Closed form solution for CoCo bond price and sensitivities




Coupon-bearing bond reflects the coupon payments before conversion takes place

Straightforward parameterization similar to equity options



It does not model capital ratio trigger — most early issues of CoCo bonds are based on capital ratio trigger

Source: Spiegeleer and Wim Schoutens (2011) 4

20

Annexure 3: Structural Model
Model Intuition


The institution’s balance sheet structure is the main price driver
These models are based on modeling the institution’s assets and liabilities (with the difference giving the institution’s capital)



Model Inputs
Market Observable: Risk-free rate and asset value (proxied using market capitalization)

Balance Sheet linked: Bank deposits and leverage ratio
Non-Observable: Mean reversion speed for deposits, asset volatility, jump intensity, mean and volatility governing jump size



The CoCo bond is priced by Monte Carlo simulation of both the asset and the liabilities processes



The coupons paid along a given asset path are discounted, as well as the CoCo bond notional at maturity if trigger or
default has not taken place, or the conversion amount if the bond has converted




Describe processes for the institution’s assets and liabilities and impose contingent capital conversion into equity when the critical
capital-to-asset threshold has been reached

The CoCo bond price equals the (risk-neutral) expectation of the discounted cash flows



Data points for balance sheet-related information from financial statements and regulatory reports are typically available
only on a quarterly basis

Source: George Pennacchi (2010) 7

21

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