Contingent Convertible Bonds


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A presentation on CoCo Bonds by Anshuman Prasad, Risk and Analytics, Director, CRISIL GR&A

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Contingent Convertible Bonds

  1. 1. SPEAKER ANSHUMAN PRASAD Director, Risk and Analytics CRISIL Global Research & Analytics October 2013 © 2013 CRISIL Ltd. All rights reserved. Contingent Convertible Bonds
  2. 2. 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 © 2013 CRISIL Ltd. All rights reserved.  (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
  3. 3. 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 © 2013 CRISIL Ltd. All rights reserved. – 4.0 – Banco do Brasil 12.8 - others 9.7 - others 2.2 - Nomura 3.2 - others 2011 2012 2013 Source :, CRISIL GR&A Analysis, as of Sep,16 2013 3
  4. 4. 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 © 2013 CRISIL Ltd. All rights reserved.  VTB Bank 4
  5. 5. 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 © 2013 CRISIL Ltd. All rights reserved.  Principal Writedown Marketvalue 1 5
  6. 6. 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 © 2013 CRISIL Ltd. All rights reserved.  Rabobank (2010) By level of the trigger By Loss absorption mechanism Source: Bank of International Settlements 1, CRISIL GR&A Analysis 6
  7. 7. 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 © 2013 CRISIL Ltd. All rights reserved.  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
  8. 8. 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 © 2013 CRISIL Ltd. All rights reserved.  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
  9. 9. 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 © 2013 CRISIL Ltd. All rights reserved. Swiss = 19% 2.5% Capital Conservation Buffer 4.5% Common Equity Tier 1 Basel III 4.5% Common Equity Tier 1 Switzerland 2 9
  10. 10. 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 © 2013 CRISIL Ltd. All rights reserved. – 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
  11. 11. 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 © 2013 CRISIL Ltd. All rights reserved.  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
  12. 12. 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 © 2013 CRISIL Ltd. All rights reserved.  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
  13. 13. 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 © 2013 CRISIL Ltd. All rights reserved.  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
  14. 14. 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 © 2013 CRISIL Ltd. All rights reserved. Pricing Approaches Conversion Ratio Stock Price at Conv. 3 14
  15. 15. 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  © 2013 CRISIL Ltd. All rights reserved. • 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
  16. 16. 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 © 2013 CRISIL Ltd. All rights reserved. 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
  17. 17. 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,, August 2011 9. Francesca Di Girolamo, Francesca Campolongo, Jan De Spiegeleer, Wim Schoutens (2012), Contingent Conversion Convertible Bond: New avenue to raise bank capital © 2013 CRISIL Ltd. All rights reserved. 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
  18. 18. © 2013 CRISIL Ltd. All rights reserved. Stay Connected | Twitter | LinkedIn | YouTube | Facebook
  19. 19. 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 © 2013 CRISIL Ltd. All rights reserved. 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
  20. 20. 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 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  © 2013 CRISIL Ltd. All rights reserved. Coupon-bearing bond reflects the coupon payments before conversion takes place Straightforward parameterization similar to equity options Limitations of the Model  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
  21. 21. 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) Modeling Methodology  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  © 2013 CRISIL Ltd. All rights reserved. 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 Limitations of the Model  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