1. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 1 of 8
What is the rationale behind contingent capital and other hybrid debt instruments?
Can you explain the main trade-offs at play behind their most important design
features?
In this report, I will begin by defining hybrid securities and contingent capital notes, then
discuss the design features (language and structure) of the two securities. I will also look
at recent hybrid issues, their structures and how they have evolved. Then, I will look at
reasons why corporates and financial institutions issue such securities. Given, that tax
regimes differ by region and a uniform treatment is still pending, analyses on tax will be
limited. This report will focus on issuers, regulation facing CCNs, rating agencies and
investors.
Hybrid Corporate Debt: What is it?
Hybrid debt is essentially a fixed-coupon paying note with no set maturity (perpetual) that
is junior or sub-ordinated to other debt in the capital structure. Figure 1 illustrates the
seniority of claims. In bankruptcy or liquidation scenario, the debt ranks junior to all other
debt and is only paid once all other obligations or claims are satisfied, implying a lower
recovery.
For pricing and recovery analysis, sub-debt carries a recovery rate of 20% versus 40% for
senior debt. The investors are paid a premium for the additional risk they take and the
spread is subject to the credit profile of each issuer.
Typical Corporate Balance Sheet Typical Capital Structure
Current Assets
Senior Secured Debt
Senior Unsecured Debt
+ Subordinated Debt
Fixed Assets
Hybrid
Equity
Figure 1: Example of a corporate balance sheet and capital structure.
Figure 2 below shows a recent hybrid issued by Orange and its structure. The hybrid has
no set maturity and has call dates as well as coupon step-up language, which resets the
coupon.

2. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 2 of 8
Figure 2
Source: Natixis, Ideas – Fixed Income, June 2014.
Contingent Capital Notes (CCNs)- What are they?
Contingent Capital Notes are hybrid securities issued by financial institutions (FI). These
come in various forms; Enhanced Capital Notes (ECNS), Alternative Tier 1 (AT1),
Contingent Convertible Securities (Cocos), and T2 Cocos but essentially they are all junior
ranking or second lien debt that carry a loss absorbing mechanism. They provide leverage
and an “equity buffer” for the issuer. At times of crisis, these automatically covert into
equity i.e. when the banks capital ratio falls below a set trigger level.
Furthermore, they provide a tax efficient way of raising capital and are complimentary to
the issuers CET (common equity) ratios, which is a focus for all banks following Basel III
requirements. The focus for banks is to issue the right debt; one that meets the required
percentage for risk weighted assets (RWA) in T1 capital and meets the leverage ratio
requirement i.e.T1/Exposure measure, which in laymen terms is total assets plus off
balance sheet items.
CCN’s were introduced in late 2009 following an asset liability management exercise by
Lloyds Treasury to replace existing legacy Lower Tier 2 (LT2), Upper Tier 2 (UT2) and Tier
1 (T1) debt. The new instruments carried a predefined trigger option that allowed the
issuer (in this case, Lloyds) to convert their debt into equity, which essentially allowed that
bank to increase its core capital without the needed to tap equity capital markets. The
investors were paid an attractive coupon to compensate for this risk. Attractive proposition
at the time given over 40% of equity was still owned by the government.
Language and Features:
The common features and their impact for hybrids are shown in figure 3.
The corporates main aim is to get the highest equity treatment from rating agencies at the
lowest cost possible. The obvious cost is paying investors the risk premium i.e. a high
coupon.
Features Impact
Cash Cumulative
Interest Deferral
Issuers right to defer coupon payment but the interest is
cumulative and compounded.
Dividend Pusher
Either forces coupon payment on the hybrid or limit any
coupon or dividend payment on instruments ranking pari
passu or subordinated to the hybrid debt in the event of
coupon cancellation on this debt.
Replacement
Capital Covenant
(RCC)
The obligation or intent to replace the hybrid debt with capital
of similar or better quality.
Mandatory Interest
Deferral
Covenants, if breached, require coupon to be deferred.
Proffered by ratings agencies.
Coupon Step-up
Call options accompanied by a coupon step-up associated
with the call dates.
Change of Control
(Coca)
Protects investors in the event of takeover of the parent
company, with a 500bps coupon step-up in most cases.
Alternative Coupon
Satisfaction
Mechanism (ACSM)
Option offering compensation (most often in shares) for
investors at the time of coupon cancellation.
Figure 3

3. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 3 of 8
Source: www.hughyieldbonds.com/covenants
Issuance: The re-emergence
The issuance of subordinated bonds by corporates re-emerged in mid 2010 where utilities
and telecoms dominated this space. The rationale was simple for the two sectors: high
capital expenditure and stretched balance sheets. The corporate hybrids allow issuers to
issue debt and earn partial equity treatment by the credit rating agencies (please note: the
treatment language by credit agencies has changed hence the partial equity treatment).
Furthermore, tax breaks also provide an incentive to issue hybrid as one can treat interest
as an expense and still get favorable equity treatment. However, I believe a combination of
low interests rates, central bank action (namely QE) and inflow of money made hybrids
and cocos compelling for investor that lead to record hybrid issuance (figure 4b) – in 2014,
we saw 46bnEur Corporate Hybrid (figure 4) and 50bnEur Cocos (Bloomberg, 2015).
Figure 4 a Figure 4 b
Source: Dealogic and FT Source: Markit, BNP Paribas, Bloomberg
Credit Rating Agencies: Rating a Hybrid and Cocos
i) Corporate Hybrids
Ratings agencies rate the hybrid debt a few notches below the senior debt but this differs
from issuer to issuer and by methodologies. One can assume, as a rule of thumb, that
hybrids are rated two to three notches below senior debt. The lower the rating, the higher
the risk and the closer it is to equity treatment.
Key features analyzed by agencies for a corporate hybrid are: subordination, coupon
deferral language and maturity. A summary of these (required by the top three ratings
agencies) is shown in figure 5. So, naturally issuers’ structure their hybrid to their issue
qualifies for the 50% equity treatment.

4. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 4 of 8
Figure 5
Source: Western Asset Management Monthly Report, 2013
Figure 6 shows a RNS issued by Moody’s following their assessment of Telefonica’s
hybrid issue from 2013. Moody provides its credit rationale and rating.
Figure 6
Source: www.telefonica.com/investors

5. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 5 of 8
ii) CCN’s
The approach by agencies on Contingent Capital Notes differs to that of corporate hybrids.
Historically, the key elements for T1 Perps (legacy CCNS) were the following:
a) "Going concern"?
b) "Gone-concern"?
c) Is the loss-absorbing hybrid there when needed?
The considerations above are self-explanatory. However, as the regulatory framework
evolved under Basel III, issuers and their treasury departments were innovative (funkier) in
their structures to satisfy: a) the regulators, b) rating agencies but more importantly, c) the
investor base.
The funkier structures and regulatory developments have led to agencies scrutinising the
CCNS further and looking at them on a case-to-case basis to fully understand the special
features.
The most interesting one (for me) is the recent Societe General 8.75% 49 AT1 that, in
addition to being a “going concern”, carries write down and write up language. So, at times
of distress the issue is written down as a “going concern” but as the bank recovers, the
investors have write-up language the kicks in – increasing the likely hood of getting their
principle investment back. The issue also has multiple triggers including regulatory calls to
protect the issuer from the evolving regulatory framework i.e. if it ceases to qualify the
issue as AT1.
Figure 7 (below) shows a summary of recent CCNs issued and their structures and
features.
Figure 7 (also see appendix)
Source: BNP Research: Cocos – European Credit Strategy Sep 2013.
The above table shows the complexity of the recent CCNs and how they have evolved
over the last decade. Banks are essentially looking at innovative ways to comply with the
regulators while reducing their cost of capital and engaging the investors. The rational for
the bank is clear: to get favourable treatment for CET calculation from the CCN.

6. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 6 of 8
Assessing Hybrids
For investors, the most important features when assessing hybrids are: ratings, language
in the offering memorandum, reputational risk of the issuer, rationale for issuance i.e. use
of proceeds and LBO risk. These are explained further in figure 8.
Figure 8
Source: Western Asset Management, Publication June 2013.
Conclusion
In summary, for corporates the incentive to issue hybrids is to diversify funding, tax breaks
and equity credit from rating agencies. For banks, it is to boost investor confidence and
have an equity cushion in case of a credit crisis.
In the current climate, hybrid issuance via CCNs and corporate hybrid is led by purely by
technicals. Investors are chasing yield and hybrids provide an attractive coupon but the
risks (in my view) are not fully compensated for (figure x).
Investors are attracted by the lower trigger levels on CCNs (in some cases as low as 5%)
and there is widespread belief that the sovereigns or the ECB will step-in at times of crisis
but they should remember that this is second tier debt that, like that case of Irish Banks,
can have haircuts. More importantly, most securities are a “going concern” that
automatically converts into equity before any form of government intervention comes into
play.
In my view, investors should avoid issuance with covenant lights features and should focus
their efforts into national champions (for corporates) and banks with a higher parent rating
that provide a hold-co guarantee. Issuers’ rationale for these is compelling in the current
climate but they need to keep in mind that these instruments can become costly if
regulation or methodologies change. Furthermore, there could be a contagion effect if
investor confidence fades away.
Word Count Inc. Headings and Subheadings: 1189.
Ratings:
This
is
more
important
for
investors.
One
should
pay
close
attention
to
the
full
capital
structure
of
the
issuer
and
where
the
debt
fits.
While
holding
company
(HoldCo)
ratings
are
important,
one
should
pay
attention
to
where
the
debt
lies
in
case
of
default,
leverage
buy-­‐outs
and
how
interest
and
principal
payment
are
treated
following
ratings
action
(HoldCo
vs.
Opco).
Document
Language:
Terms
and
structures
vary
from
issuer
to
issuer
and
industry
to
industry
and
one
should
pay
close
attention
of
the
offering
memorandum/circular
to
fully
understand
what
happens
in
case
of
default
and
what
is
the
interest
deferral
language
i.e.
non-­‐dividend
payment,
must-­‐pay
or
deferred/cumulative
interest
payments.
Reputational
Risk:
One
should
assess
the
size
of
hybrid
relative
to
the
issuers
total
enterprise
value
and
the
coupon
vs.
the
dividend.
Issuers
are
concerned
about
their
reputation
and
more
importantly,
their
ability
to
raise
debt
via
debt
capital
markets
so
the
smaller
the
hybrid
issue
the
better
as
deferring
and
non-­‐payment
of
coupons
can
dent
investor
confidence.
Rationale
for
issuance:
Historically,
hybrids
have
been
an
expensive
method
to
raise
funding
but
in
the
current
low
rates
environment
we
are
in
these
provide
an
incentive
for
issuers
to
raise
funding
at
a
lower
cost
of
capital.
LBO:
The
option
to
defer
interest
could
raise
serious
issues
for
investors.
In
case
of
a
LBO,
the
hybrid
can
essentially
turn
in
a
zero
coupon
perp
bond.

7. Sandeep
Kumar
Analysing
and
Mitigating
Risk
CID
Number:
01020501
Page 7 of 8
REFERENCE LIST
• BNP Paribas: European Credit Research: Valuing the Coco collection, September
2013.
• Natixis Asset Management: Ideas Fixed Income, June 2014.
• Moody’s Investor Services: Ratings Action, September 2013. Deutsche Bank
• Financial Times (2014), Telefonica SA. [Online] Available from:
http://markets.ft.com/research/Markets/Tearsheets/Summary?s=TEF:MCE
[Accessed: April 3rd
2015]
• Practical Law: Hybrid Securities: an Overview. Available from:
www.gobal.practicallaw.com/1-517-1581
[Accessed: April 3rd
2015]
• Western Asset Management, Corporate Hybrids, May 2013.