Recent Developments And Trends In The Market For CoCos: A Primer
Contingent convertible capital instruments (CoCos) are hybrid capital securities that absorb losses when the capital of the issuing bank falls below a certain level. In this article, we go over the structure of CoCos, trace the evolution of their issuance, and examine their pricing in primary and secondary markets. CoCo issuance is primarily driven by their potential to satisfy regulatory capital requirements. The bulk of the demand for CoCos has come from small investors, while institutional investors have been relatively restrained so far. The spreads of CoCos over other subordinated debt greatly depend on their two main design characteristics – the trigger level and the loss absorption mechanism. CoCo spreads are more correlated with the spreads of other subordinated debt than with CDS spreads and equity prices.
Recent Developments And Trends In The Market For CoCos: A Primer – Introduction
Private investors are usually reluctant to provide additional external capital to banks in times of financial distress. In extremis, the government can end up injecting capital to prevent the disruptive insolvency of a large financial institution because nobody else is willing to do so. Such public sector support costs taxpayers and distorts the incentives of bankers.
Contingent convertible capital instruments (CoCos) offer a way to address this problem. CoCos 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. Then debt is reduced and bank capitalisation gets a boost. Owing to their capacity to absorb losses, CoCos have the potential to satisfy regulatory capital requirements.
In this article, we examine recent developments and trends in the market for CoCos. Our analysis is based on a data set that covers $70 billion worth of CoCos issued between June 2009 and June 2013. Several trends stand out.
First, the main reasons for issuing CoCos are related to their potential to satisfy regulatory capital requirements. Second, the bulk of the demand has come from private banks and retail investors, while institutional investors have been relatively restrained so far. Third, CoCo yields tend to be higher than those of higher-ranked debt instruments of the same issuer and are highly dependent on their two main design characteristics – the trigger level and the loss absorption mechanism. Finally, CoCo yields tend to be more correlated with those of other subordinated debt than with CDS spreads (on senior unsecured debt) and equity prices.
The rest of this article is organised as follows. In the first section, we describe the structure and design of CoCos. We discuss the reasons for CoCo issuance in the second section. In the third section, we examine the main groups of investors in CoCos. In the fourth and fifth sections, we study the pricing of CoCos in primary and secondary markets, respectively. The final section concludes.
Structure and design of CoCos
The structure of CoCos is shaped by their primary purpose as a readily available source of bank capital in times of crisis. In order to achieve that objective, they need to possess several characteristics. First, CoCos need to automatically absorb losses prior to or at the point of insolvency. Second, the activation of the loss absorption mechanism must be a function of the capitalization levels of the issuing bank. Finally, their design has to be robust to price manipulation and speculative attacks.
CoCos have two main defining characteristics – the loss absorption mechanism and the trigger that activates that mechanism (Graph 1). CoCos can absorb losses either by converting into common equity or by suffering a principal writedown. The trigger can be either mechanical (ie defined numerically in terms of a specific capital ratio) or discretionary (ie subject to supervisory judgment).
One of the most important features in the design of a CoCo is the definition of the trigger (ie the point at which the loss absorption mechanism is activated). A CoCo can have one or more triggers. In case of multiple triggers, the loss absorption mechanism is activated when any trigger is breached.
Triggers can be based on a mechanical rule or supervisors’ discretion. In the former case, the loss absorption mechanism is activated when the capital of the CoCo-issuing bank falls below a pre-specified fraction of its risk-weighted assets. The capital measure, in turn, can be based on book values or market values.
Book-value triggers, also known as accounting-value triggers, are typically set contractually in terms of the book value of Common Equity Tier 1 (CET1) capital as a ratio of risk-weighted assets (RWA). The effectiveness of book-value triggers depends crucially on the frequency at which the above ratios are calculated and publicly disclosed, as well as the rigour and consistency of internal risk models, which can vary significantly across banks5 and time. As a result, book-value triggers may not be activated in a timely fashion.
Market-value triggers could address the shortcoming of inconsistent accounting valuations. These triggers are set at a minimum ratio of the bank’s stock market capitalisation to its assets. As a result, they can reduce the scope for balance sheet manipulation and regulatory forbearance.
However, market-value triggers may be difficult to price and could create incentives for stock price manipulation. The pricing of conversion-to-equity CoCos with a market-value trigger could suffer from a multiple equilibria problem. More specifically, since CoCos must be priced jointly with common equity, a dilutive CoCo conversion rate could make it possible for more than one pair of CoCo prices and equity prices to exist for any given combination of bank asset values and non-CoCo debt levels. Furthermore, under certain circumstances, holders of CE CoCos may have an incentive to short-sell the underlying common stock in order to generate a self-fulfilling death spiral and depress the share price to the point at which the market-value trigger is breached.
Finally, discretionary triggers, or point of non-viability (PONV) triggers, are activated based on supervisors’ judgment about the issuing bank’s solvency prospects. In particular, supervisors can activate the loss absorption mechanism if they believe that such action is necessary to prevent the issuing bank’s insolvency. PONV triggers allow regulators to trump any lack of timeliness or unreliability of book-value triggers. However, unless the conditions under which regulators will exercise their power to activate the loss absorption mechanism are made clear, such power could create uncertainty about the timing of the activation.
Loss absorption mechanism
The loss absorption mechanism is the second key characteristic of each CoCo. A CoCo can boost the issuing bank’s equity in one of two ways. A conversion-to-equity (CE) CoCo increases CET1 by converting into equity at a pre-defined conversion rate. By contrast, a principal write-down (PWD) CoCo raises equity by incurring a write-down.
For CoCos with a CE loss absorption mechanism, the conversion rate can be based on (i) the market price of the stock at the time the trigger is breached; (ii) a pre-specified price (often the stock price at the time of issuance); or (iii) a combination of (i) and (ii). The first option could lead to substantial dilution of existing equity holders as the stock price is likely to be very low at the time the loss absorption mechanism is activated. But this potential for dilution would also increase the incentives for existing equity holders to avoid a breach of the trigger. By contrast, basing the conversion rate on a pre-specified price would limit the dilution of existing shareholders, but also probably decrease their incentives to avoid the trigger being breached. Finally, setting the conversion rate equal to the stock price at the time of conversion, subject to a pre-specified price floor, preserves the incentives for existing equity holders to avoid a breach of the trigger, while preventing unlimited dilution.
The principal writedown of a PWD CoCo could be either full or partial. Most PWD CoCos have a full writedown feature. However, there are exceptions. For example, in the case of the CoCo bond issued by Rabobank in March 2010, holders of CoCos would lose 75% of the face value and receive the remaining 25% in cash. One criticism of this type of loss absorption mechanism is that the issuer would have to fund a cash payout while in distress.
At the moment, the CoCo market is still relatively small, but it is growing. Banks have issued approximately $70 billion worth of CoCos since 2009. By comparison, during the same period they have issued around $550 billion worth of non-CoCo subordinated debt and roughly $4.1 trillion worth of senior unsecured debt. Nevertheless, CoCo issuance volumes have increased in each of the last two years and are on pace to grow once again in 2013.
The regulatory treatment of CoCos against the background of the need to boost capital has been the main driver of the supply of those instruments. Under Basel III, CoCos could qualify as either Additional Tier 1 (AT1) or Tier 2 (T2) capital (Graph 2).8 The current Basel III framework contains two key contingent capital elements: (i) a PONV trigger requirement, which applies to all AT1 and T2 instruments; and (ii) a going-concern contingent capital requirement, which applies only to AT1 instruments classified as liabilities.
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