contingent convertible bonds
DESCRIPTION
A presentation on CoCo Bonds by Anshuman Prasad, Risk and Analytics, Director, CRISIL GR&ATRANSCRIPT
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Contingent Convertible Bonds
October 2013
ANSHUMAN PRASAD
Director, Risk and Analytics
CRISIL Global Research & Analytics
SPEAKER
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Executive Summary
Rising Importance of CoCo Bonds
– CoCo bonds or contingent capital has taken off in a big way and can be considered a
new asset class
– CoCo issuances have exceeded $20 billion in 2012 and 2013
– 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)
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Rising interest in CoCo Bonds
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)
3
Source : Contingentconvertibles.com, CRISIL GR&A Analysis, as of Sep,16 2013
3.2 - others
12.8 - others
2.2 - Nomura
3.5 – Banco do Brasil
9.7 - others
1.3 - others
2.3 -Allied Irish bk.
3.7 – Soc Activos
4.0 – Banco do Brasil
16.3 - Lloyds Banking
group
1.7 - Rabobank
4.0 - Rabobank
4.0 - UBS
7.0 - Credit Suisse
0
5
10
15
20
25
2009 2010 2011 2012 2013
16.3
3.0
11.7
20.7
24.1
US
D B
illio
ns
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CoCo Bonds: An Overview (2/2)
Why were Coco Bonds introduced?
– As a bail-in mechanism to infuse additional capital under adverse market conditions
– Can be used as regulatory capital under Additional Tier 1 and Tier 2 of Basel guidelines
– 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
4
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
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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
5
Source: Bank of International Settlements 1
Main design features of
CoCos
Trigger Loss Absorption
Mechanism
Mechanical Discretionary Conversion to
Equity
Principal
Writedown
Book-value Market-
value
and
and/or or
or
Features of CoCo Bonds
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Comparison of Features of CoCo Bonds Issued
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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)
By level of the trigger
High-trigger CoCo Additional Tier 1 capital Société Générale (2013)
Low-trigger CoCo Tier 2 capital Nomura (2011), Bank of Ireland (2013)
By Loss absorption mechanism
Conversion into equity Fixed number or value of shares Lloyds bank (2009)
Principal write-down Write-off of principal value Rabobank (2010)
Source: Bank of International Settlements 1, CRISIL GR&A Analysis
Recent Issuances
– Predominantly additional Tier 1 issuances with a discretionary trigger-based principal
write-down feature
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Regulatory Treatment of CoCo Bonds
Tax Treatment of CoCo Bonds can be complex
– Depending on the features, CoCo bonds can be treated as debt or equity for tax
purposes
– If treated as equity, coupon payments may not be eligible for tax benefits, reducing their
attractiveness
– 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)
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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
– 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
Open Issues still to be addressed include:
– 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
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Swiss Contingent Capital Regulations
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Basel II Basel III Switzerland
Basel II = 8%
Basel III = 10.5%
Swiss = 19%
2% Common Equity Tier 1 (CET1)
2% Other Qualifying Tier 1 (OQT1)
4% Tier 2
4.5% Common Equity
Tier 1
2.5% Capital Conservation
Buffer
1.5% Other Qualifying Tier 1 (OQT1)
2% Tier 2
0% up to 2.5% Countercyclical
Buffer
4.5% Common Equity
Tier 1
+ 5.5%
Common Equity Tier 1
3% High Level
Trigger CoCos
6% Low Level
Trigger CoCos tbd
SIFI capital surcharge
+
>13%
Swiss regulations allow low-and high-level triggers at 5% and 7%
Source: IMF Staff discussion note 2
Comparison of Swiss Proposals and Basel III Proposal
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Performance of New issues
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
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88
92
96
100
104
108
112
3-Apr-13 21-Apr-13 9-May-13 27-May-13 14-Jun-13 2-Jul-13 20-Jul-13 7-Aug-13 25-Aug-13 12-Sep-13 30-Sep-13
CREDIT SUISSE UBS AG BANCO BILBAO VIZCAYA ARG BARCLAYS BANK PLC
Source: Bloomberg, CRISIL GR&A Analysis
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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
11
One-year performance of selected CoCos
95
100
105
110
115
Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13
MQGAU 10 1/4 06/20/57 LLOYDS 7 5/8 10/14/20 SRENVX 7 1/4 09/29/49
CS 7 1/8 03/22/22 VTB 9 1/2 12/29/49 RABOBK 6 7/8 03/19/20
Avg. Return: 5.8%
Avg. Sharpe Ratio: 1.4
Source: Bloomberg, CRISIL GR&A Analysis
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Lower adoption by hedge funds, banks and insurance firms
Higher acceptance by private banks and retail investors followed by asset management firms
Typical Investors in CoCo Bonds
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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
Europe and Asia-based private investors and private banks are the key target
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
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
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The Payoff Structure of a CoCo Bond is quite different from that of a Convertible Bond
Valuation of CoCo Bonds (1/2)
13
0
20
40
60
80
100
P
S
Convertible CoCo Bond Floor ParityS
Source : Spiegeleer and Wim Schoutens 4
Design of a Valuation Model for a CoCo Bond is driven by:
Modeling the underlying trigger
Capital Ratio, Market Price, CDS Spreads, Discretionary, Multivariate
Value of CoCo at conversion
Fixed Value Conversion, Fixed Number Conversion, Principal Write-off
Additional Features
Callability
Unlimited downside,
limited upside
Limited downside,
unlimited upside
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Determinants of a Contingent Convertible's Value
Valuation of CoCo Bonds (2/2)
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Value of Bond Part Value of Equity Part Probability of Conversion
Trigger Underlying Trigger Level
Maturity
Coupon Rate
Conversion
Ratio
Nominal
Amount
Conversion
Fraction
Risk
-free
Rate
Stock
Price
at
Conv.
Source : Markus P.H. Buergi 3
Pricing Approaches
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)
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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
• E.g., Share prices and CDS spreads
– 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
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
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Assessing Risks
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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 Adverse News Causing Trigger
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 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
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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
4. Jan De Spiegeleer, Wim Schoutens 4 (2011), Pricing Contingent Convertibles: A Derivatives Approach, Katholieke Universiteit Leuven, March 18,
2011 Financial
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
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
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Annexure 1: Credit Derivatives Approach
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Modeling Methodology
Credit Spread,
LambdaTrigger
Here, Recovery Rate = Stock Price Initial/Conversion Price
LambdaTrigger is the default intensity and is related to the Survival Probability
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
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
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
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Limitations of the Model
Annexure 2: Equity Derivatives Model
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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) -
Coupon-bearing bond reflects the coupon payments before conversion takes place
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
Modeling Methodology
Model Inputs
Stock price, Dividend yield and Implied volatility of embedded options — all market observable
Closed form solution for CoCo bond price and sensitivities
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
Model Intuition
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Model Intuition
Modeling Methodology
Limitations of the Model
Annexure 3: Structural Model
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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)
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
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
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