At a recent credit conference in London panellists in a session on bank capital asked the audience whether contingent convertible bonds (cocos) should be included in credit market indices. The session was held in a large room, which was packed with attendees, but not a single hand went up. It seems that proponents of these instruments still have a long way to go in convincing the market of their viability.
Ever since Lloyds and Rabobank issued the only two contingent convertible deals to take place so far (in late 2009 and earlier this year) activity in the market has been confined to a great deal of talk and not much else. But with the Swiss Federal Councils announcement in early October of its acceptance of Cocos as part of a banks capital requirement, interest in the instruments has reached a new level. Credit Suisse will surely issue one.
Market sources suggest that Barclays is also sounding out potential investor interest in a new structure for contingent convertibles. This would trigger, given a severe deterioration in tangible capital, a certain portion of the principal on a bond being written down and this forgiven principal becoming effective equity in the bank. Should conditions then improve, the holder of the instrument might still be repaid at par on the remaining debt portion. As well as having to agree a term sheet and pricing with at least one large anchor investor, Barclays will need the Financial Services Authoritys approval to count this as permanent capital before bringing it to market.
Chicken and egg
The problem is not just regulatory uncertainty although that remains a big headache for all forms of hybrid capital. "I am not surprised that the coco market has not developed because of the lack of regulatory clarity," says Vinod Vasan managing director and head of European DCM financial institutions group at Deutsche Bank. "If the regulators had endorsed it at the outset then we could be in a very different position. The regulators are asking if there is a natural buyer base for these instruments but it is a chicken and egg situation because instruments need to be issued to prove that there is a market for them and for investors to gear up to buy them."
Given that the Swiss regulator is the only one to have given Cocos the green light so far, rumours abound that either Credit Suisse or UBS is poised to test the water (the Swiss Federal Council has recommended that the two largest Swiss banks should hold up to 9% of risk-weighted capital as Cocos by 2019). However, in mid-November UBS chief financial officer John Cryan effectively shot such speculation down, stating that the bank did not plan to sell any Cocos until it had rebuilt its capital base. "Until our capital is significantly larger than it is today, we wont be testing the coco market," he told investors.
Cocos as bonuses?
However, Credit Suisse chief executive Brady Dougan has described Cocos as a market that "can develop and will develop", saying that the bank sees some benefits in issuing them "sooner rather than later". Indeed, he has even hinted that Credit Suisse might pay staff Cocos as part of their remuneration packages an idea he told Bloomberg was "interesting".
"Someone should go away and think this through properly. You need to respect the hierarchy of capital instruments"
Georg Grodzki, Legal & General Investment Management
But the most pressing question surrounding Cocos still remains: who will buy them? Opinions among fixed-income buyers are mixed at best. "These bonds should not be eligible for our funds," said Georg Grodzki, head of credit research at Legal & General Investment Management, at a Citi conference in November. "You cant expect a fixed-income investor to do something that is well beyond their mandate." He describes the concept of an institution suffering permanent or partial write-down when the equity is not completely wiped out as "flying in the face of corporate finance". He says: "If we no longer become holders of the companys assets on default we are being called upon to re-equitize the company. This is a totally different ball game."
But Vasan at Deutsche Bank believes that fixed-income investors will change as the market changes. "There may be a buyer base for Cocos in fixed income," he says. "The investor base has been changing for hybrids which are attractive to more hedge funds and retail buyers. Fixed-income investors will need to find yield in the future so they will have probably have a look at Cocos."
Roger Doig, credit analyst, and Sarang Kulkarni, fixed-income fund manager, at Schroders, reckon that it is all a question of price. "Regulators appear to have become enamoured with the concept of contingent capital instruments," they say. "We see such instruments as quasi-equity not debt from an investment perspective. As such, we would only look to participate where the coupon was high enough to provide equity-like returns."
But the principal bone of contention between regulators and investors over Cocos remains that of discretion. The two existing deals (which have consistently traded at or above their issue price) incorporated objective triggers: 7% equity capital ratio for Rabobank and 5% core capital ratio for Lloyds. Any suggestion that regulators should have discretion over when hybrid capital triggers are tripped is completely unpalatable to most buyers. "Regulatory intervention to trip triggers is an anathema," says Grodzki.
Vasan remains optimistic that appetite is there but mostly from hedge funds and retail buyers. "The interaction between hybrids and Cocos needs to be worked out," he concedes, adding: "It is quite optimistic to assume that equity investors will buy them they have never really found it easy to buy structured products." But he reckons that hedge funds have more flexibility and, like retail buyers, can look at Cocos without mandate restrictions. Indeed, over 30% of buyers in the Lloyds deal were hedge funds.
Other fixed-income investors will take some convincing. "Someone should go away and think this through properly," says Grodzki. "You need to respect the hierarchy of capital instruments."