This kind of bond emerged after the financial crisis, and was designed by regulators in order to create a sort of bail-in bond. The aim of these bonds is to reduce the need for the public sector to get involved in bailing out financial institutions. The use of these CoCo bonds helps banks meet new regulations imposed on them, which aim to give the banks rapid liquidity if needed when cash flows substantially decrease. Banks are forecast to issue more of these types of bonds, but because of their high volatility and risk, investors might not be willing to purchase these assets.
Contingent Convertible bonds, or CoCo bonds, are hybrid capital securities that allow banks to skip interest payments without defaulting, providing a buffer when the banks run into a life-threatening situation. These instruments bridge the gap between debt and equity. They are a fixed income instruments that have equity-like characteristics. They are also the riskiest type of debt that banks issue, and so carry a high coupon. If Banks get into financial difficulty, e.g. takes losses or their assets fall in value, the bonds can be converted into equity, or written down to stabilize the balance sheet. This usually happens when certain triggers are met; this is generally a company’s capital reserves decreasing below a certain threshold, e.g. the core tier 1 (CT1) capital falls below 7%. It is therefore clear that CoCo’s main use in practice is for crisis management, and preventing large organizations from needing government support. If CoCos fall sharply, it can be a sign the bank is beginning to fail, which in turn can be used as a tool, not only to decrease liabilities on the balance sheet, but also a financial indicator to the market. The idea behind CoCos is that they take losses when the bank is in trouble which then gets priced into the market rather than Governments having to bail them out. “In this way, they are designed to be “bailed in”, in order to avoid taxpayer bailouts.”
The Conversion Trigger and The Conversion Mechanism are the key characterists of a Contingent Convertible bond. These two features crucially determine the effectiveness of contingent convertible bonds in stabilizing banks. It is critical for the regulators to have a proper understanding of those key characteristics and its structuring such that CoCos fulfil their intended function as well as for the banks to price such instruments.
The conversion trigger
The conversion trigger is one of the most important elements in the design of the contingent convertible bond, it defines the point at which the loss absorption mechanism is activated and leads to a stronger capital structure of the coco bond issuer. In a situation of multiple triggers, the loss absorption mechanism is activated when any trigger is breached.
The trigger of a CoCo bond is the threshold that determines the probability and the risk of conversion. It is critical that the trigger is executed early enough to actually help out the bank in times of financial distress, whilst being activated only when is needed.
However, a conversion trigger can be either on a mechanical rule or supervisor’s discretion. Each mechanical conversion trigger is characterized by a trigger variable when the capital of the issuing bank falls below a pre-specified fraction of its risk-weighted assets.
Systemic triggers
Systemic conversion triggers are more inclined towards the conditions of the whole financial system rather than of an individual bank, with the objective to increase capitalizations of the entire system in the indication of a potential financial crisis. Examples of systemic triggers are, liquidity conditions, a market volatility index, or supervisory declaration of systemic risk. The potential choice of a systemic conversion trigger depends on the purposes of the Contingent Convertible bond. If the Contingent Convertible bond is only triggered in the event of a financial crisis, it would mean forgoing any benefits from the market-based discipline effect, as there would be no reason for banks to manage their own individual risks in an efficient way, as their individual financial condition would have no influence on the conversion of the CoCo bond. Hence, an individual bank would not be stabilized if there is any evidence of a financial crisis, in other words, the CoCos would not be triggered. Even though systemic triggers have the advantage of efficiently providing large amounts of equity in the event of a systemic distress, they utterly destroy the positive goad offered by the more individual, bank-specific triggers. (see appendix II)
In cases where the equity ratios approach the lower trigger level, risk prevention stimulus have most definitely malfunctioned. Banks have, unfortunately, failed to rescue themselves. Therefore, we may conclude that if the Contingent Convertible Bonds are meant to stabilize a bank that is in financial distress, then in most cases systemic trigger are not the most appropriate.
Bank specific- triggers
The conversion of a Contingent Convertible bond with bank-specific triggers is based solely on the economic state of a single bank. These could include a bank’s core T1 capital ratio, the bank’s share price or CDS price, or an assessment of nonviability by the supervisor. However, bank-specific triggers might not be enough to rescue the whole financial system in the event of a crisis, they still play a critical role helping each distinct bank in times of their particular financial crisis. These bank-specific triggers tend to be easier to rate and price compared to the previous discussed systemic triggers. (see appendix I)
Capital Based-Triggers
The capital ratio trigger is probably the best set in line with the regulatory capital framework. However, since it is often a lagging indicator of the current state of the bank, it may trigger the conversion a bit too late. When the Tier 1 Capital ratio falls below a certain value, which has either been determined by regulators, the capital ratio based trigger converts the CoCos into equity. As seen in the 2007-2009 financial crisis, the lack of credibility causes a death spiral to the financial institution. A capital ratio trigger provides additional equity capital to the distressed Financial Institution, when it needs the most, preventing the death spiral from happening by safeguarding the investor’s trust.
γ Low-Triggers
Low-Trigger Contingent Convertible bonds might give the banks the power to delay required recapitalizations for a longer period of time. Whilst capital ratio decline and shareholders have reduced value at risk, the banks tend to incur higher risks. In this line of thought, we could say that if the CoCos will only convert at the point of bank financial distress, banks will continue to operate under high leverage, with the mentality that they can always shift risks from shareholders to lenders and taxpayers. If low-trigger CoCos have high-trigger Contingent Convertible bonds ahead of them, they will be less likely to be converted, as the high-triggers will convert long before the capital ratio reach the lower levels. On the other hand, these low-triggers can be useful for controlled resolutions, by setting the trigger at the point of nonviability, regulators can assure that the private sector will be involved in the bank restructuring process of the bank, as was done in the case of Lloyds Banking Group (LBG). There is a possibility that market credibility in a bank’s financial health could weaken and instigate liquidity pressure as bank capital approaches the conversion trigger.
γ High-Triggers
This triggers can be crucial for crisis prevention. Instruments with high triggers could help mitigate systemic risks by ensuring recapitalization before a bank reaches the critical levels and potential loss of broader market access. Early conversion could impact negatively, as the initial shareholders might lose control over financial institution, and due to diminishing leverage and increased number of outstanding shares, the dilution in share prices would cause a decline in earnings for the shareholders. As a further matter, it could instigate conversion panic. Although a conversion would restore solvency and credibility to the converting institution, this could ultimately result in a systemic flood of conversion as the confidence in the remaining financial system declines. The level of the trigger will determine the conversion risk. Risk averse investors are more likely to be drawn by the low-trigger CoCos which are rather unlikely to convert. Whilst, the more dynamic and speculative investors would prefer the high-trigger ones with greater probability of conversion and loss, but also higher returns.
Market-Based Triggers
The market-based triggers could address the shortcoming of inconsistent accounting valuations. When the issuer’s share price or CDS spread breaches a certain level, the market-based triggers convert into equity. On the opposite of the capital-based triggers, the market-based triggers are more accurate and frequently observable. The other key point of these triggers is the fact that they do reflect changes in a bank’s financial health more rapidly and are not easily subject to manipulation by the firm’s accountants.
For the reasons mentioned above, these triggers are more suitable to indicate the financial situation of the issuer bank, however, they can be more easily subject to market manipulation, thereby raising the risk of untimely conversion. Although, this problem can be addressed by to some extent by, for instance, basing the conversion triggers on the moving average of a market price.
Arbitrageurs would buy CoCos, short-sell the respective share in order to push the price below the trigger level, profiting from anticipated share price dilution following conversion. In some more severe cases, short sellers could provoke a destabilization of the whole financial institution, if they are able to raid the market to the point where the shares get almost worthless. However, specifying the conversion price appropriately, such that losses are inflicted to bondholders in case of conversion could be a manner to address to this problem.
Regulatory discretionary triggers
Regulatory Conversion triggers belong to the discretionary conversion triggers, as the decision to convert the bonds is entirely to the discretion of the CoCo bond issuers regulator. These class of conversion triggers can be seen as the last resort. As the decision whether the CoCos should or should not be triggered is reliant on the discretion of the regulator, it can be tricky to predict the probability of conversion. These regulatory triggers should be implemented in accordance with the previous discussed mechanical triggers, as the latter is assumed to be the main conversion driver in case of financial distress of the bank.
Dual trigger
Some cases would require the implementation of two triggers in order to ensure accurately timed conversions. The combination of a bank-specific and systemic trigger would generate broader recapitalization of the financial market whilst allowing different measures for each individual bank. However, the combination of triggers is prone to produce mixed signals and, it also enhances the risk of combining the worst characteristics of triggers.
Loss absorption mechanism
The second key design feature of a Contingent Convertible bond is the loss absorption mechanism. A CoCo can enhance the issuing bank’s equity either by a conversion-to-equity or by a principal write down.
Conversion-to-equity
In principle, a contingent bond can convert into shares in a number of different ways, most obviously by fixing either the number of shares received on conversion or by fixing the dollar value of shares received. The conversion rate determines the burden sharing between shareholders and bondholders, as it defines how many shares each CoCo bondholder will receive in exchange of his face value. If CoCos have a high rate of dilution among conversion, as in the fixed value conversion, shareholders will have to suffer losses of dilution and contrariwise if dilution among conversion is low, as in the fixed number conversion, the bondholders will have to carry the main portion of the burden.
γ Fixed Share conversion – At conversion, bonds are converted into a certain number of shares;
γ Fixed Value conversion – At conversion, bonds are converted into share with fixed dollar value;
γ Par conversion – At conversion, the bond holder receives a number of shares equivalent to the bond’s face value;
γ Premium conversion – At conversion, the bondholder receives a number of shares that worth less than the par value of the bond;
γ Discount conversion – At conversion, the bondholder receives a number of shares that are worth more than the par value of the bond.
When fixed value conversion is combined with a high- trigger bondholders could take over a bank with respectable residual value, thus making a conversion highly attractive to investors. On the other hand, combined with low-triggers a conversion is less attractive as bondholders are left with shares of a bank with diminished entity value.
It can be problematic to identify the share price at issuance on the fixed number conversion, as the share prices are expected to decline when the trigger value approaches. Fixed number conversion can have reduced share manipulations, since the conversion ratio is already determined at issuance. Shareholders benefit from the certainty of dilution upon conversion, whereas bondholders are most likely to incur losses.
Principal write-down
While equity conversion allows for potential upside gain after conversion, fixed income portfolio managers may prefer a write-down feature, as they may be prohibited in their mandates from holding securities such equities. Write-downs can be either temporary or permanent, and also full or partial, depending on the individual characteristics of the distress.
Although most of the principal write-downs CoCos have a full write-down feature, there are cases where the write-down is partial. For instance, in march 2010 Rabobank issued CoCos where holders would suffer a 75% automatic “haircut” and receive the remaining 25% in cash if Tier 1 ratio falls below 7%.
Structure of a contingent convertible bond
If the triggers are never met to satisfy the conversion, then the bonds will never become equity and will simply be paid back at maturity date as a normal bond would. If, however, any of the triggers are pulled then the conversion will occur and the bond will turn into company equity. It should also be noted that at any time the issuer of the bond can miss coupon payments if they are financially unable to pay it out. This can lead to a situation where the holder still holds the bond but is gaining no interest on it. And lastly, the holder can write down the debt, effectively leaving the investor with less, hence the relatively high interest paid on these risky assets from an investor’s point of view. Writing the bonds down can also make the bonds worthless, rapidly decreasing their value on the secondary market.
Funded conversion structure
In these structure investors buy the CoCos and new money flows into the issuing financial institution as an upfront payment. As the CoCos either convert to equity or suffer a principal write-down, the issuer’s bank balance sheet is reinforced and hence increasing the bank’s market credibility. The investor pays a nominal value to the issuer’s bank to receive a CoCo that pays regular coupons. If the trigger levels are never reached, the investor receives the nominal value at maturity. However, on the case of conversion the CoCo bond converts to shares.
Unfunded conversion structure
The unfunded structure is the opposite of the funded structure. There is no upfront payment, as the issuing bank only receives the nominal value upon conversion, therefore boosting liquidity to the bank in times of distress. The issuing bank enters in a counterparty agreement with the SPV, therefore is obligated to pay regular insurance premium. At the same time, investor pays the nominal value to the same SPV and receives a CoCo bond that pay regular coupons. The unfunded structure is normally financed over a special purpose vehicle (SPV), that issues the CoCo bonds and obtains the money which is directly invested in a highly independent riskless collateral. In case of conversion, the collateral is sold, cash is transferred to the issuing bank and investors receive the shares or suffer a “haircut”.
Advantages
The first major advantage of contingent convertible bonds is their use in preventing large scale collapses of major financial institutions. When these companies face financial trouble, the quick conversion of these bonds into equity leads to a rapid increase in capital and gives these companies the liquidity to prevent the worst case scenario of bankruptcy. This obviously is a huge benefit, as the collapse of these institutions would cause major social and economic problems, particularly in the country they originate from.
Furthermore, it reduces the likelihood of government bailouts funded by taxpayer money on companies that are seen as “too big to fail” due to the negative social and economic impact it would produce. This risk can cause big problems for governments worldwide, as the general public in these countries do not want their taxes spent on bailing out organizations, whose incompetence has got them into financial difficulty. Having these CoCos gives the firms a last resort, where they can quickly inject capital, increasing their reserves, and thus preventing the need for government bailouts.
It can also give these large financial institutions a reason to be more conservative in their operations and use risk management effectively. This is due to the fact that whilst these CoCos give the company a buffer against a rapid decrease in capital, pulling the trigger and converting them leads to a dilution to the current shareholders, therefore decreasing the earnings per share. As a company’s number one goal is to satisfy their shareholders, this situation is not desirable.
Disadvantages
Some of the disadvantages suggested surround the triggers that lead to the conversion from debt into equity. Firstly, if using the capital based triggers, which are based on accounting data, there can be delays in application which render the CoCos useless. Accounting data is only produced quarterly, so the response to a crisis can be months late which prevents the CoCo from absorbing losses, which is its primary objective. Furthermore, the triggers based on regulation can result in ad hoc decision making, which in turn creates uncertainty. This uncertainty is due to the fact that if the regulation authorities establish a threshold when a conversion will take place, then both investors and ratings agencies will have a tough time trying to assess the likelihood of conversions taking place. Lastly, if market based triggers are used, for example the share price: which is the most common, then this can lead to poor decision making on when to trigger the conversion. Stock prices and other market measures are subject to both manipulation and volatility, making them an unreliable source of data. Also, many of these measures may be affected by inputs that have no relation to the financial position of the bank.
One limitation of the use of CoCos is the potential to create inefficiency in the
market. When CoCos are used and the trigger is pulled converting the debt into equity and preventing a company from defaulting this can lead to an undesirable situation. If companies conduct their business inefficiently, and have poor practices and weak management then they sometimes have no place in the market, ore more likely should be willing to change. CoCos can prevent this.
Another disadvantage of CoCos in the wider economic community is that they can cause more problems than solutions. If other large financial institutions decide to invest in CoCos of a big bank, for example, then they themselves will have to absorb large losses; if the trigger pulls, they suddenly go from receiving a high coupon to owning equity in a weak company, which now has the additional problem of diluted shares reducing the earnings per share.
As a bank becomes closer to pulling the trigger and converting the bonds, it can lead to investor reactions that will send the bank in a “death spiral”. If investors see that there is a chance of their investment being turned into equity and downgraded, they will potentially short sell shares in the company counteracting their current long position on the CoCos. This could be the final blow and cause the bank to fail.
1. Discuss the potentially problems that a U.K. bank that already bought CoCos in order to pass Basel and EU regulation may have after Brexit.
Cocos are a complex type of bond and should only really be brought by investors that understand the risks. There are both risks that apply to Cocos as well the uncertainty of Brexit. When Article 50 is triggered Britain will begin the process of leaving the European Union this however is a relatively long process which will take around two years during this period EU law will still apply in the Britain.
The specific risks that apply to owners of Cocos in relation to Brexit would depending on the type of exist that Britain can negotiate. If a soft Brexit strategy is on the table the added risk of leaving the European Union might be limited. This is because the banking sector would still be in the single market. This is not to say there wouldn’t be an impact, there is a relatively high likelihood the value of the bonds would slump because of uncertainty and possible higher default rates. If a hard Brexit strategy is formed this could greatly affect the British banks ability to trade. Forecast by many specialists Moody’s, Bank of England, IMF are negative. Moody’s believe England might be downgraded “credit rating” and might enter a recession or slow down. This would affect the pricing on bonds all over European because of the interlinked nature of the financial system.
European banks aren’t in a great position and though Basel and EU regulation is designed to make the banks less risky it costs a huge amount for the bank to implement some estimate €120 million each for Basel because this and the increased capital requirements the returns at all banks been effected. Though banks are not obliged to own Cocos it is quite likely that they will hold some. Though Cocos are risky and the performance in their natural currency has been poor in the last few months it is important to translate this to sterling. The loss in the GBP/EUR will have increase the value of the Cocos considerably. UK banks leaving the EU might actually allow them to have less stringent capital requirements.